UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C.  20549





FORM
10-Q










x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
the quarterly period ended September 30, 2009





or





 ̈
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the transition period from ______
to _____





Commission
File Number 0-23971









Citizens
South Banking Corporation


(Exact
name of registrant as specified in its charter)







Delaware
            54-2069979(State
      or other jurisdiction of
            (I.R.S.
      Employerincorporation
      or organization)
            Identification
      Number)





519
South New Hope Road, Gastonia, NC  28054


(Address
of principal executive offices)





(704)
868-5200


(Registrant's
telephone number, including area code)








Indicate
by check mark whether the Registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the Registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  YesxNo ̈





Indicate
by check mark whether the Registrant has submitted electronically and posted on
its corporate website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the Registrant was required to file
such reports).  Yes ̈No ̈





Indicate
by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definitions of “accelerated filer”, “large accelerated
filer” and “small reporting company” in Rule 12b-2 of the Exchange
Act.





Large
      accelerated filer ̈
              
              Accelerated
      filer    ̈Non-accelerated
      filer ̈
              
              Smaller
      Reporting Company  x





Indicate
by check mark whether the Registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act.)  Yes ̈Nox





As of
November 12, 2009, there were 7,526,854 shares outstanding shares of the
Registrant’s common stock, $0.01 par value.




Citizens
South Banking Corporation


Form
10-Q for the Quarterly Period Ended September 30, 2009





Table
of Contents





Index


PagePART
      I.  FINANCIAL INFORMATIONItem
      1.   Financial Statements:Consolidated
      Statements of Financial Condition as of September 30, 2009 (unaudited) and
      December 31, 2008
                      2Consolidated
      Statements of Operations for the Three and Nine Months Ended September 30,
      2009 and 2008 (unaudited)
                      3Consolidated
      Statements of Changes in Stockholders’ Equity for the Nine Months
      EndedSeptember
      30, 2009 and 2008 (unaudited)
                      4Consolidated
      Statements of Cash Flows for the Nine Months Ended September 30, 2009 and
      2008 (unaudited)
                      5Notes
      to Consolidated Financial Statements
                      6Item
      2.  Management's Discussion and Analysis of Financial Condition
      and Results of Operations
                      16Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk
                      28Item
      4.  Controls and Procedures
                      28PART
      II.  OTHER INFORMATIONItem
      1.  Legal Proceedings
                      29Item
      1A.  Risk Factors
                      29Item
      2.  Unregistered Sales of Equity Securities and Use of
      Proceeds
                      32Item
      3.  Defaults Upon Senior Securities
                      33Item
      4.  Submission of Matters to a Vote of Security
      Holders
                      33Item
      5. Other Information
                      33Item
      6.  Exhibits
                      33SignaturesCertifications







PART
I. FINANCIAL INFORMATION


ITEM
1. Financial Statements


1





Citizens
South Banking Corporation


Consolidated
Statements of Financial Condition


(Dollars
in thousands, except share and per share data)





September 30,
                        
                        
                        December 31,2009
                        
                        
                        2008(unaudited)Assets:Cash
      and cash equivalents:Cash
      and due from banks
                        
                        $
                        9,846
                        
                        
                        $
                        9,444Interest-earning
      bank balances
                        
                        
                        35,650
                        
                        
                        
                        613Total
      cash and cash equivalents
                        
                        
                        45,496
                        
                        
                        
                        10,057Investment
      securities available for sale, at fair value
                        
                        
                        79,112
                        
                        
                        
                        109,180Investment
      securities held to maturity, at amortized cost
                        
                        
                        11,062
                        
                        
                        
                        -Loans:Loans
      receivable, net of unearned income and deferred fees
                        
                        
                        616,793
                        
                        
                        
                        626,688Allowance
      for loan losses
                        
                        
                        (9,499
                        )
                        
                        
                        (8,026
                        )Loans
      receivable, net
                        
                        
                        607,294
                        
                        
                        
                        618,662Other
      real estate owned
                        
                        
                        3,444
                        
                        
                        
                        2,601Premises
      and equipment, net
                        
                        
                        15,367
                        
                        
                        
                        16,834Accrued
      interest receivable
                        
                        
                        2,317
                        
                        
                        
                        2,609Federal
      Home Loan Bank stock, at cost
                        
                        
                        4,149
                        
                        
                        
                        4,793Bank-owned
      life insurance
                        
                        
                        17,341
                        
                        
                        
                        16,813Intangible
      assets
                        
                        
                        30,282
                        
                        
                        
                        30,525Other
      assets
                        
                        
                        4,744
                        
                        
                        
                        5,139Total
      assets
                        
                        $
                        820,608
                        
                        
                        $
                        817,213Liabilities
      and Stockholders' Equity:Deposits:Demand
      deposit accounts
                        
                        
                        147,796
                        
                        
                        
                        122,731Money
      market deposit accounts
                        
                        
                        115,727
                        
                        
                        
                        103,271Savings
      accounts
                        
                        
                        10,999
                        
                        
                        
                        10,708Time
      deposits
                        
                        
                        327,092
                        
                        
                        
                        344,778Total
      deposits
                        
                        
                        601,614
                        
                        
                        
                        581,488Borrowed
      money
                        
                        
                        110,711
                        
                        
                        
                        124,365Other
      liabilities
                        
                        
                        4,293
                        
                        
                        
                        6,640Total
      liabilities
                        
                        
                        716,618
                        
                        
                        
                        712,493Stockholders'
      Equity:Preferred
      stock, $0.01 par value, 1,000,000 shares authorized; 20,500 shares
      issuedand
      outstanding at September 30, 2009 and December 31, 2008
                        
                        
                        20,569
                        
                        
                        
                        20,507Common
      stock, $0.01 par value, 20,000,000 shares authorized; 9,062,727
      sharesissued
      at September 30, 2009 and December 31, 2008, 7,526,854 shares
      outstandingat
      September 30, 2009, and 7,515,957 shares outstanding at December 31,
      2008
                        
                        
                        48,587
                        
                        
                        
                        48,099Retained
      earnings
                        
                        
                        34,270
                        
                        
                        
                        36,089Accumulated
      other comprehensive income
                        
                        
                        564
                        
                        
                        
                        25Total
      stockholders' equity
                        
                        
                        103,990
                        
                        
                        
                        104,720Total
      liabilities and stockholders' equity
                        
                        $
                        820,608
                        
                        
                        $
                        817,213





See
accompanying notes to consolidated financial statements.


2





Citizens
South Banking Corporation


Consolidated
Statements of Operations (unaudited)


(Dollars
in thousands, except share and per share data)





Three Months
                              
                              
                              Nine MonthsEnded September 30,
                              
                              
                              Ended September 30,2009
                              
                              
                              2008
                              
                              
                              2009
                              
                              
                              2008Interest
      Income:Loans
                              
                              $
                              8,376
                              
                              
                              $
                              9,416
                              
                              
                              $
                              25,176
                              
                              
                              $
                              28,160Investment
      securities
                              
                              
                              1,077
                              
                              
                              
                              1,377
                              
                              
                              
                              3,623
                              
                              
                              
                              3,952Interest-bearing
      deposits
                              
                              
                              28
                              
                              
                              
                              13
                              
                              
                              
                              46
                              
                              
                              
                              149Total
      interest income
                              
                              
                              9,481
                              
                              
                              
                              10,806
                              
                              
                              
                              28,845
                              
                              
                              
                              32,261Interest
      Expense:Deposits
                              
                              
                              2,791
                              
                              
                              
                              3,997
                              
                              
                              
                              9,515
                              
                              
                              
                              13,397Borrowed
      funds
                              
                              
                              1,156
                              
                              
                              
                              1,427
                              
                              
                              
                              3,480
                              
                              
                              
                              3,783Total
      interest expense
                              
                              
                              3,947
                              
                              
                              
                              5,424
                              
                              
                              
                              12,995
                              
                              
                              
                              17,180Net
      interest income
                              
                              
                              5,534
                              
                              
                              
                              5,382
                              
                              
                              
                              15,850
                              
                              
                              
                              15,081Provision
      for loan losses
                              
                              
                              3,975
                              
                              
                              
                              720
                              
                              
                              
                              6,825
                              
                              
                              
                              1,815Net
      interest income after provision for loan losses
                              
                              
                              1,559
                              
                              
                              
                              4,662
                              
                              
                              
                              9,025
                              
                              
                              
                              13,266Noninterest
      Income:Service
      charges on deposit accounts
                              
                              
                              859
                              
                              
                              
                              802
                              
                              
                              
                              2,427
                              
                              
                              
                              2,256Mortgage
      banking income
                              
                              
                              215
                              
                              
                              
                              169
                              
                              
                              
                              975
                              
                              
                              
                              650Other
      loan fees
                              
                              
                              36
                              
                              
                              
                              84
                              
                              
                              
                              175
                              
                              
                              
                              296Dividends
      on FHLB stock
                              
                              
                              -
                              
                              
                              
                              40
                              
                              
                              
                              -
                              
                              
                              
                              168Income
      from bank-owned life insurance
                              
                              
                              202
                              
                              
                              
                              195
                              
                              
                              
                              570
                              
                              
                              
                              571Net
      gain on sale of assets
                              
                              
                              952
                              
                              
                              
                              13
                              
                              
                              
                              1,016
                              
                              
                              
                              275Other
      noninterest income
                              
                              
                              237
                              
                              
                              
                              189
                              
                              
                              
                              603
                              
                              
                              
                              549Total
      noninterest income
                              
                              
                              2,501
                              
                              
                              
                              1,492
                              
                              
                              
                              5,766
                              
                              
                              
                              4,765Noninterest
      Expense:Compensation
      and benefits
                              
                              
                              2,570
                              
                              
                              
                              2,553
                              
                              
                              
                              7,588
                              
                              
                              
                              7,601Occupancy
      and equipment expense
                              
                              
                              632
                              
                              
                              
                              662
                              
                              
                              
                              1,958
                              
                              
                              
                              2,012Professional
      fees
                              
                              
                              233
                              
                              
                              
                              200
                              
                              
                              
                              707
                              
                              
                              
                              639Amortization
      of intangible assets
                              
                              
                              81
                              
                              
                              
                              126
                              
                              
                              
                              243
                              
                              
                              
                              402FDIC
      deposit insurance
                              
                              
                              232
                              
                              
                              
                              25
                              
                              
                              
                              825
                              
                              
                              
                              58Valuation
      adjustment on other real estate owned
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              175
                              
                              
                              
                              -Restructuring
      expense
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              220Impairment
      of securities
                              
                              
                              333
                              
                              
                              
                              468
                              
                              
                              
                              547
                              
                              
                              
                              468Other
      noninterest expenses
                              
                              
                              1,148
                              
                              
                              
                              1,111
                              
                              
                              
                              3,362
                              
                              
                              
                              3,330Total
      noninterest expense
                              
                              
                              5,229
                              
                              
                              
                              5,145
                              
                              
                              
                              15,405
                              
                              
                              
                              14,730Net
      income (loss) before income tax expense (benefit)
                              
                              
                              (1,169
                              )
                              
                              
                              1,009
                              
                              
                              
                              (614
                              )
                              
                              
                              3,301Income
      tax expense (benefit)
                              
                              
                              (672
                              )
                              
                              
                              187
                              
                              
                              
                              (887
                              )
                              
                              
                              647Net
      income (loss)
                              
                              
                              (497
                              )
                              
                              
                              822
                              
                              
                              
                              273
                              
                              
                              
                              2,654Dividends
      on preferred stock
                              
                              
                              262
                              
                              
                              
                              -
                              
                              
                              
                              774
                              
                              
                              
                              -Net
      income (loss) available to common stockholders
                              
                              $
                              (759
                              )
                              
                              $
                              822
                              
                              
                              $
                              (501
                              )
                              
                              $
                              2,654Net
      income (loss) per common share:Basic
                              
                              $
                              (0.10
                              )
                              
                              $
                              0.11
                              
                              
                              $
                              (0.07
                              )
                              
                              $
                              0.36Diluted
                              
                              $
                              (0.10
                              )
                              
                              $
                              0.11
                              
                              
                              $
                              (0.07
                              )
                              
                              $
                              0.36Weighted
      average common shares outstanding:Basic
                              
                              
                              7,419,206
                              
                              
                              
                              7,358,086
                              
                              
                              
                              7,405,199
                              
                              
                              
                              7,380,236Diluted
                              
                              
                              7,419,206
                              
                              
                              
                              7,386,513
                              
                              
                              
                              7,405,199
                              
                              
                              
                              7,414,274





See
accompanying notes to consolidated financial statements.


3




Citizens
South Banking Corporation


Consolidated
Statements of Changes in Stockholders' Equity


(Dollars
in thousands, except per share data)





Retained
                  
                  
                  AccumulatedEarnings
                  
                  
                  OtherPreferred
                  
                  
                  Common
                  
                  
                  Substantially
                  
                  
                  ComprehensiveStock
                  
                  
                  Stock
                  
                  
                  Restricted
                  
                  
                  Income
                  
                  
                  TotalBalance,
      December 31, 2008
                  
                  $
                  20,507
                  
                  
                  $
                  48,100
                  
                  
                  $
                  36,088
                  
                  
                  $
                  25
                  
                  
                  $
                  104,720Net
      loss
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (501
                  )
                  
                  
                  -
                  
                  
                  
                  (501
                  )Accumulated
      discount on preferred stock
                  
                  
                  62
                  
                  
                  
                  
                  
                  
                  
                  (62
                  )
                  
                  
                  
                  
                  
                  
                  -Allocation
      of shares purchased with loan to ESOP
                  
                  
                  
                  
                  
                  
                  137
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  137Other
      comprehensive income, net of tax
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  539
                  
                  
                  
                  539Cash
      dividends of $0.125 per share
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,235
                  )
                  
                  
                  
                  
                  
                  
                  (1,235
                  )Stock
      option expense
                  
                  
                  
                  
                  
                  
                  79
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  79Exercise
      of stock options
                  
                  
                  
                  
                  
                  
                  20
                  
                  
                  
                  (20
                  )
                  
                  
                  
                  
                  
                  
                  -Prorata
      vesting of RRP grants
                  
                  
                  
                  
                  
                  
                  251
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  251Balance,
      September 30, 2009 (unaudited)
                  
                  $
                  20,569
                  
                  
                  $
                  48,587
                  
                  
                  $
                  34,270
                  
                  
                  $
                  564
                  
                  
                  $
                  103,990





See
accompanying notes to consolidated financial statements.





4





Citizens
South Banking Corporation


Consolidated
Statements of Cash Flows (unaudited)


(Dollars
in thousands)





Nine
      MonthsEnded September 30,2009
                
                
                2008Cash
      flows from operating activities:Net
      income (loss)
                
                $
                (501
                )
                
                $
                2,654Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for loan losses
                
                
                6,825
                
                
                
                1,815Depreciation
                
                
                785
                
                
                
                836Impairment
      of securities
                
                
                547
                
                
                
                468Net
      gain on sale of investment securities
                
                
                (1,281
                )
                
                
                (284
                )Net
      loss on sale of other real estate owned
                
                
                263
                
                
                
                16(Gain)
      loss on sale of premises and equipment
                
                
                1
                
                
                
                (7
                )Writedown
      on other real estate owned
                
                
                175
                
                
                
                -Deferred
      loan origination fees
                
                
                (23
                )
                
                
                73Allocation
      of shares to the ESOP
                
                
                137
                
                
                
                137Stock
      based compensation
                
                
                79
                
                
                
                43Vesting
      of shares issued for the Recognition and Retention Plan
                
                
                251
                
                
                
                248Decrease
      in accrued interest receivable
                
                
                292
                
                
                
                634Amortization
      of intangible assets
                
                
                243
                
                
                
                402Increase
      in other assets
                
                
                (3,939
                )
                
                
                (1,106
                )Decrease
      in other liabilities
                
                
                (2,258
                )
                
                
                (480
                )Net
      cash provided by operating activities
                
                
                1,596
                
                
                
                5,449Cash
      flows from investing activities:Net
      (increase) decrease in loans
                
                
                4,567
                
                
                
                (69,545
                )Proceeds
      from the sale of investment securities
                
                
                47,977
                
                
                
                31,808Proceeds
      from the sale of premises and equipment
                
                
                815
                
                
                
                15Proceeds
      from the sale of other real estate owned
                
                
                2,185
                
                
                
                295Maturities
      and prepayments of investment securities,
    available-for-sale
                
                
                15,911
                
                
                
                13,739Purchases
      of investment securities, available-for-sale
                
                
                (32,183
                )
                
                
                (38,629
                )Purchases
      of investment securities, held-to-maturity
                
                
                (11,086
                )
                
                
                -(Purchase)
      sale of FHLB stock
                
                
                644
                
                
                
                (1,120
                )Purchases
      of premises and equipment
                
                
                (135
                )
                
                
                (213
                )Net
      cash provided by (used in) investment activities
                
                
                28,695
                
                
                
                (63,650
                )Cash
      flows from financing activities:Net
      increase (decrease) in deposits
                
                
                20,127
                
                
                
                (5,837
                )Net
      increase (decrease) in borrowed money
                
                
                (13,654
                )
                
                
                51,234Dividends
      paid
                
                
                (1,236
                )
                
                
                (1,875
                )Issuance
      of common stock for options
                
                
                -
                
                
                
                54Repurchase
      of common stock
                
                
                -
                
                
                
                (1,019
                )Post
      retirement benefit accrual
                
                
                -
                
                
                
                (350
                )Increase
      (decrease) in advances from borrowers for insurance and
    taxes
                
                
                (89
                )
                
                
                179Net
      cash provided by financing activities
                
                
                5,148
                
                
                
                42,386Net
      increase (decrease) in cash and cash equivalents
                
                
                35,439
                
                
                
                (15,815
                )Cash
      and cash equivalents at beginning of year
                
                
                10,057
                
                
                
                29,739Cash
      and cash equivalents at end of year
                
                
                45,496
                
                
                
                13,924Supplemental
      non-cash investing activity:Reclassification
      of loans to other real estate owned
                
                $
                3,330
                
                
                $
                596





See
accompanying notes to consolidated financial statements.




5




CITIZENS
SOUTH BANKING CORPORATION


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS





Note
1 – Basis of Presentation





The
accompanying unaudited consolidated financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America (“GAAP”) and pursuant to the rules and regulations of the Securities and
Exchange Commission (“SEC”).  They do not include all of the
information and footnotes required by such accounting principles for complete
financial statements, and therefore should be read in conjunction with the
audited consolidated financial statements and accompanying footnotes in the
Company’s Annual Report on Form 10-K for the year ended December 31, 2008. The
consolidated balance sheet at December 31, 2008, was derived from the audited
consolidated financial statements presented in the Company’s Annual Report on
Form 10-K for the year ended December 31, 2008.





The
preparation of financial statements in conformity with GAAP requires management
to make estimates and assumptions that affect reported amounts of assets and
liabilities and the reported amounts of revenues and expenses during the
reporting period.  The more significant estimates that are
particularly susceptible to significant change relate to the determination of
the allowance for loan losses and other-than-temporary impairments on
securities.  Actual results could differ from those
estimates.





In
management’s opinion, the accompanying unaudited consolidated financial
statements reflect all adjustments necessary for a fair presentation of the
interim financial statements as of and for the three- and nine-month periods
ended September 30, 2009 and 2008 and have been included as required by
Regulation S-X Rule 10-01.  The accompanying unaudited consolidated
financial statements include the accounts of Citizens South Banking Corporation
(the “Company”) and its wholly-owned subsidiary, Citizens South Bank (the
“Bank”).  All significant intercompany transactions have been
eliminated in consolidation.  Certain amounts reported in prior
periods have been reclassified to conform to the current
presentation.  Such reclassifications had no effect on total assets,
net income (loss), or stockholders’ equity as previously
reported.  Results for the three- and nine-month period ended
September 30, 2009, are not necessarily indicative of the results that may be
expected for future periods, including the year ending December 31,
2009.





Note
2 - Recent Accounting Pronouncements





The
following is a summary of recent authoritative pronouncements that could impact
the accounting, reporting, and/or disclosure of financial information by the
Company.





In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standard (“SFAS”) No. 141(revised 2007), Business Combinations,
Accounting Standards Codification (“ASC”) 805,Business Combinations) “ASC
805”, which replaces SFAS No. 141.  ASC 805 establishes
principles and requirements for recognition and measurement of assets,
liabilities and any noncontrolling interest acquired due to a business
combination.  ASC 805 expands the definitions of a business and a
business combination, resulting in an increased number of transactions or other
events that will qualify as business combinations.  Under ASC 805 the
entity that acquires the business (the “acquirer”) will record 100 percent
of all assets and liabilities of the acquired business, including goodwill,
generally at their fair values. As such, an acquirer will not be permitted to
recognize the allowance for loan losses of the acquiree.  ASC 805
requires the acquirer to recognize goodwill as of the acquisition date, measured
as a residual.  In most business combinations, goodwill will be
recognized to the extent that the consideration transferred plus the fair value
of any noncontrolling interests in the acquiree at the acquisition date exceeds
the fair values of the identifiable net assets acquired.  Under this
statement, acquisition-related transaction and restructuring costs will be
expensed as incurred rather than treated as part of the cost of the acquisition
and included in the amount recorded for assets acquired.  This
statement is effective for fiscal years beginning after December 15,
2008.  The adoption of ASC 805 on January 1, 2009, had no
material effect on the Company’s consolidated financial
statements.


6




In
March 2008, the FASB issued SFAS No. 161,Disclosures about Derivative
Instruments and Hedging Activities, and an amendment of FASB Statement
No. 133 (ASC 815-10-65-1,Transition and Effective Date
Related to FASB Statement No. 161) “ASC 815”. ASC 815 applies to all
derivative instruments and related hedged items accounted for under SFAS
No. 133,Accounting for
Derivative Instruments and Hedging Activities. ASC 815 requires entities
to provide greater transparency about (a) how and why an entity uses
derivative instruments, (b) how derivative instruments are related hedged
items are accounted for under SFAS No. 133 and its related interpretations,
and (c) how derivative instruments and related hedged items affect an
entity’s financial position, results of operations and cash flows. To meet those
objectives, ASC 815 requires (1) qualitative disclosures about objectives
for using derivatives by primary underlying risk exposure (e.g., interest rate,
credit or foreign exchange rate) and by purpose or strategy (fair value hedge,
cash flow hedge, net investment hedge, and non-hedges), (2) information
about the volume of derivative activity in a flexible format that the preparer
believes is the most relevant and practicable, (3) tabular disclosures
about balance sheet location and gross fair value amounts of derivative
instruments, income statement and other comprehensive income location of gain
and loss amounts on derivative instruments by type of contract, and
(4) disclosures about credit-risk related contingent features in derivative
agreements. ASC 815 is effective for financial statements issued for fiscal
years and interim periods beginning after November 15, 2008. The adoption
of ASC 815 on January 1, 2009, had no material effect on the Company’s
consolidated financial statements.





In May
2009, the FASB issued SFAS No. 165, Subsequent Events,(ASC 855,
Subsequent Events) “ASC
855”.  ASC 855 establishes general standards of accounting for and
disclosures of events that occur after the balance sheet date but before
financial statements are issued or are available to be issued. In particular,
this statement sets forth: (1) the period after the balance sheet date during
which management of a reporting entity should evaluate events or transactions
that may occur for potential recognition or disclosure in the financial
statements, (2) the circumstances under which an entity should recognize events
or transactions occurring after the balance sheet date in its financial
statements, and (3) the disclosures that an entity should make about events or
transactions that occurred after the balance sheet date.  The Company
adopted this statement effective for the quarterly period ended June 30, 2009,
and its adoption had no material impact on the Company’s financial condition or
results of operations.  See Note 11 for additional
information.





In
June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards
CodificationTM and the Hierarchy of Generally Accepted Accounting Principles(ASC 105, Generally
Accepted Accounting Principles) “ASC 105”. ASC 105 replaces SFAS No. 162,
The Hierarchy of Generally
Accepted Accounting Principles, and establishes the FASB Accounting Standards
CodificationTM (“Codification”) as the source of authoritative accounting
principles recognized by the FASB to be applied by nongovernmental entities in
the preparation of financial statements in conformity with GAAP.  On
the effective date of this Statement, the Codification will supersede all
then-existing non-SEC accounting and reporting standards.  ASC 105 is
effective for financial statements issued for interim and annual periods ending
after September 15, 2009.  The codification is effective for these
third quarter financial statements and the principal impact is limited to
disclosures as all future references to authoritative literature will be
referenced in accordance with the codification.





In
April 2009, the FASB issued the following three FSPs intended to provide
additional application guidance and enhance disclosures regarding fair value
measurements and impairments of securities:




1) FSP
FAS 157-4,Determining Fair
Value When the Volume and Level of Activity for the Asset or Liability Have
Significantly Decreased and Identifying Transactions That Are Not
Orderly  (ASC 820-10-65-4,Transition Related to
FASB Staff Position FAS 157-4 ), provides additional guidance for
estimating fair value in accordance with SFAS No. 157 when the volume and
level of activity for the asset or liability have decreased
significantly. This FSP also provides guidance on identifying circumstances
that indicate a transaction is not orderly. The provisions of this FSP are
effective for the Company’s interim period ending on June 30,
2009. The adoption of this FSP at June 30, 2009 did not have a
material impact on the Company’s statement of operations and balance
sheet.


7




2) FSP
FAS 107-1 and APB 28-1,Interim Disclosures about Fair Value of Financial Instruments (ASC
825-10-65-1,Transition
Related to FSP FAS 107-1 and APB 28-1 ), requires disclosures about fair
value of financial instruments in interim reporting periods of publicly traded
companies that were previously only required to be disclosed in annual financial
statements. The provisions of this FSP are effective for the Company’s
interim period ending on June 30, 2009 and only amends the disclosure
requirements about fair value of financial instruments in interim periods. The
Company adopted this FSP during the second quarter of 2009. See Note 10 for
additional information.




3) FSP
FAS 115-2 and FAS 124-2,Recognition and Presentation of Other-Than-Temporary Impairments (ASC
320-10-65-1,Transition
Related to FSP FAS 115-2 and FAS 124-2 ), amends current
other-than-temporary impairment guidance in GAAP for debt securities to make the
guidance more operational and to improve the presentation and disclosure of
other-than-temporary impairments on debt and equity securities in the financial
statements. This FSP does not amend existing recognition and measurement
guidance related to other-than-temporary impairments of equity
securities. The provisions of this FSP are effective for the Company’s
interim period ending on June 30, 2009.




In August
2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-05,Fair Value Measurements and
Disclosures (Topic 820) – Measuring Liabilities at Fair Value. This
ASU provides amendments for fair value measurements of liabilities. It
provides clarification that in circumstances in which a quoted price in an
active market for the identical liability is not available, a reporting entity
is required to measure fair value using one or more techniques. ASU 2009-05
also clarifies that when estimating a fair value of a liability, a reporting
entity is not required to include a separate input or adjustment to other inputs
relating to the existence of a restriction that prevents the transfer of the
liability. ASU 2009-05 is effective for the first reporting period
(including interim periods) beginning after issuance or fourth quarter
2009. The Company is assessing the impact of ASU 2009-05 on our financial
condition, results of operations, and disclosures.





Other
accounting standards that have been issued or proposed by the FASB or other
standards-setting bodies are not expected to have a material impact on the
Company’s financial statements.





Note
3 – Earnings (Loss) per Share





The
Company is required to report both basic and diluted earnings (loss) per share
(“EPS”).  Basic EPS is calculated by dividing net income (loss)
available to common stockholders by the weighted average number of common shares
outstanding for the period.  Diluted EPS is calculated by dividing net
income (loss) available to common stockholders by the sum of the weighted
average number of common shares outstanding for the period and potential common
stock. Potential common stock consists of additional common stock that would
have been outstanding as a result of the exercise of dilutive stock
options.  In determining the number of shares of potential common
stock, the treasury stock method was applied.  The treasury method
assumes that the number of shares issuable upon exercise of the stock options is
reduced by the number of common shares assumed purchased at market prices with
the proceeds from the assumed exercise of the common stock options plus any tax
benefits received as a result of the assumed exercise.


8


For the
nine-month periods ended September 30, 2009 and 2008, options to purchase
796,967 shares and 754,290 shares, respectively, were excluded from the
calculation of diluted earnings per share because the option exercise price
exceeded the average closing price of the associated shares of common stock
during the respective periods.  The following is a summary of the
diluted earnings per share calculation for the three and nine months ended
September 30, 2009 and 2008:





Three
      Months
                
                
                Nine
      MonthsEnded September 30,
                
                
                Ended September 30,2009
                
                
                2008
                
                
                2009
                
                
                2008(dollars
      in thousands, except per share amounts)Net
      income (loss) available to common stockholders
                
                $
                (759
                )
                
                $
                822
                
                
                $
                (501
                )
                
                $
                2,654Shares
      used in the computation of EPS:Weighted
      avg. number of shares outstanding
                
                
                7,419,206
                
                
                
                7,358,086
                
                
                
                7,405,199
                
                
                
                7,380,236Incremental
      shares from assumed exercise of stock options and restricted
      stock
                
                
                -
                
                
                
                28,427
                
                
                
                -
                
                
                
                34,038Weighted
      average number of shares outstanding - diluted
                
                
                7,419,206
                
                
                
                7,386,513
                
                
                
                7,405,199
                
                
                
                7,414,274Diluted
      EPS
                
                $
                (0.10
                )
                
                $
                0.11
                
                
                $
                (0.07
                )
                
                $
                0.36





Note
4 – Comprehensive Income





Comprehensive
income is the change in the Company’s equity during the period from transactions
and other events and circumstances from non-owner sources. Comprehensive income
consists of net income (loss) and other comprehensive income (loss). The
Company’s other comprehensive income (loss) and accumulated other comprehensive
income (loss) are comprised of unrealized gains and losses on certain
investments. Information concerning the Company’s other comprehensive income for
the nine-month periods ended September 30, 2009 and 2008 is as
follows:





Nine
      MonthsEnded September 30,2009
                    
                    
                    2008(Dollars
      in thousands)Net
      income (loss) available to common stockholders
                    
                    $
                    (501
                    )
                    
                    $
                    2,654Other
      comprehensive income (loss):Items
      of other comprehensive income (loss), before taxUnrealized
      gains (losses) arising during period
                    
                    
                    2,159
                    
                    
                    
                    (1,504
                    )Reclassification
      for realized gains included in net income
                    
                    
                    (1,281
                    )
                    
                    
                    (284
                    )Other
      comprehensive income (loss), before tax
                    
                    
                    878
                    
                    
                    
                    (1,788
                    )Tax
      (expense) benefit
                    
                    
                    (339
                    )
                    
                    
                    689Other
      comprehensive income (loss)
                    
                    
                    539
                    
                    
                    
                    (1,099
                    )Total
      comprehensive income
                    
                    $
                    38
                    
                    
                    $
                    1,555


9


Note
5 – Investment Securities





The
amortized cost, unrealized gains and losses, and estimated fair values of
investment securities as of September 30, 2009 and December 31, 2008, were as
follows:





Amortized
                        Cost
                      
                      
                      Unrealized
                        Gains
                      
                      
                      Unrealized
                        Losses
                      
                      
                      Estimated
                        Fair Value(Dollars
      in thousands)September 30, 2009Available
      for sale:U.S.
      Government Agency obligations
                      
                      $
                      11,000
                      
                      
                      $
                      38
                      
                      
                      $
                      -
                      
                      
                      $
                      11,038Municipal
      bonds
                      
                      
                      21,213
                      
                      
                      
                      302
                      
                      
                      
                      (179
                      )
                      
                      
                      21,336Mortgage-backed
      securities
                      
                      
                      42,708
                      
                      
                      
                      1,172
                      
                      
                      
                      (59
                      )
                      
                      
                      43,821Corporate
      bonds
                      
                      
                      1,982
                      
                      
                      
                      31
                      
                      
                      
                      (450
                      )
                      
                      
                      1,563Trust
      preferred securities
                      
                      
                      242
                      
                      
                      
                      -
                      
                      
                      
                      (1
                      )
                      
                      
                      241Equity
      securities
                      
                      
                      1,049
                      
                      
                      
                      104
                      
                      
                      
                      (40
                      )
                      
                      
                      1,113Total
      Securities
                      
                      $
                      78,194
                      
                      
                      $
                      1,647
                      
                      
                      $
                      (729
                      )
                      
                      $
                      79,112





Amortized
                          Cost
                        
                        
                        Unrealized
                          Gains
                        
                        
                        Unrealized
                          Losses
                        
                        
                        Estimated
                          Fair Value(Dollars
      in thousands)September 30, 2009Held
      to maturity:U.S.
      Government Agency obligations
                        
                        $
                        6,000
                        
                        
                        $
                        94
                        
                        
                        $
                        -
                        
                        
                        $
                        6,094Mortgage-backed
      securities
                        
                        
                        5,062
                        
                        
                        
                        140
                        
                        
                        
                        -
                        
                        
                        
                        5,202Total
      Securities
                        
                        $
                        11,062
                        
                        
                        $
                        234
                        
                        
                        $
                        -
                        
                        
                        $
                        11,296




Amortized
                        Cost
                      
                      
                      Unrealized
                        Gains
                      
                      
                      Unrealized
                        Losses
                      
                      
                      Estimated
                        Fair Value(Dollars
      in thousands)December 31, 2008Available
      for sale:U.S.
      Government Agency obligations
                      
                      $
                      500
                      
                      
                      $
                      3
                      
                      
                      $
                      -
                      
                      
                      $
                      503Municipal
      bonds
                      
                      
                      26,959
                      
                      
                      
                      91
                      
                      
                      
                      (1,246
                      )
                      
                      
                      25,804Mortgage-backed
      securities
                      
                      
                      78,376
                      
                      
                      
                      2,029
                      
                      
                      
                      (130
                      )
                      
                      
                      80,275Corporate
      bonds
                      
                      
                      1,500
                      
                      
                      
                      -
                      
                      
                      
                      (450
                      )
                      
                      
                      1,050Trust
      preferred securities
                      
                      
                      548
                      
                      
                      
                      -
                      
                      
                      
                      (179
                      )
                      
                      
                      369Equity
      securities
                      
                      
                      1,256
                      
                      
                      
                      19
                      
                      
                      
                      (96
                      )
                      
                      
                      1,179Total
      Securities
                      
                      $
                      109,139
                      
                      
                      $
                      2,142
                      
                      
                      $
                      (2,101
                      )
                      
                      $
                      109,180




10


Note
6 - Loans





For the
nine-month period ended September 30, 2009, total loans decreased by $9.9
million, or 1.6%.  The following is a summary of loans outstanding by
category at the periods presented:





September 30, 2009
                          
                          
                          December 31, 2008(Dollars
      in thousands)Real
      estate:One-to-four
      family residential
                          
                          $
                          85,591
                          
                          
                          $
                          84,777Construction
                          
                          
                          29,663
                          
                          
                          
                          71,454Commercial
      real estate
                          
                          
                          344,987
                          
                          
                          
                          321,614Commercial
      business
                          
                          
                          39,824
                          
                          
                          
                          34,451Consumer
                          
                          
                          116,682
                          
                          
                          
                          114,287Gross
      loans
                          
                          
                          616,747
                          
                          
                          
                          626,583Less:Deferred
      loan fees, net and other items
                          
                          
                          (46
                          )
                          
                          
                          (105
                          )Allowance
      for loan losses
                          
                          
                          9,499
                          
                          
                          
                          8,026Net
      loans
                          
                          $
                          607,294
                          
                          
                          $
                          618,662





The
following is a summary of construction loans outstanding at the respective
dates:





September 30, 2009
                      
                      
                      December 31, 2008(Dollars
      in thousands)Construction
      loans:One-to-four
      family residential owner-occupied
                      
                      $
                      998
                      
                      
                      $
                      3,449One-to-four
      family residential speculative
                      
                      
                      17,090
                      
                      
                      
                      34,481Commercial
      construction
                      
                      
                      11,575
                      
                      
                      
                      33,524Total
      construction loans
                      
                      $
                      29,663
                      
                      
                      $
                      71,454





The following
is a summary of commercial real estate loans at the periods
presented:





September 30, 2009
                      
                      
                      December 31, 2008(Dollars
      in thousands)Commercial
      real estate loans:Residential
      acquisition and development
                      
                      $
                      40,330
                      
                      
                      $
                      53,327Commercial
      land
                      
                      
                      41,796
                      
                      
                      
                      40,444Other
      commercial real estate
                      
                      
                      262,861
                      
                      
                      
                      227,843Total
      commercial real estate loans
                      
                      $
                      344,987
                      
                      
                      $
                      321,614


11


Note
7 - Allowance for Loan Losses and Nonperforming Assets





The
Company has established a systematic methodology for determining the adequacy of
the allowance for loan losses.  This methodology is set forth in a
formal policy and considers all loans in the portfolio.  Specific
allowances are established for certain individual loans that management
considers impaired.  The remainder of the portfolio is segmented into
groups of loans with similar risk characteristics for evaluation and analysis.
Management’s periodic evaluation of the allowance is consistently applied and
based on inherent losses in the portfolio, past loan loss experience, risks
inherent in the different types of loans, the estimated value of any underlying
collateral, current economic conditions, the borrower’s financial position, and
other relevant internal and external factors that may affect loan
collectibility. The allowance for loan losses is increased by charging
provisions for loan losses against income.  As of September 30, 2009,
the allowance for loan losses was $9.5 million, or 1.54% of total
loans.  Management believes that this amount meets the requirement for
losses on loans that management considers to be impaired, for known losses, and
for losses inherent in the remaining loan portfolio.  Although
management believes that it uses the best information available to make such
determinations, future adjustments to the allowance for loan losses may be
necessary and results of operations could be significantly adversely affected if
circumstances differ substantially from the assumptions used in making the
determinations.  An analysis of the
allowance for loan losses is as follows:





Three
      Months
                
                
                Nine
      MonthsEnded September 30,
                
                
                Ended September 30,2009
                
                
                2008
                
                
                2009
                
                
                2008(Dollars
      in thousands)Balance
      – Beginning of period
                
                $
                8,685
                
                
                $
                6,757
                
                
                $
                8,025
                
                
                $
                6,144Add:
      Provision for loan losses
                
                
                3,975
                
                
                
                720
                
                
                
                6,825
                
                
                
                1,815Loan
      recoveries
                
                
                3
                
                
                
                3
                
                
                
                145
                
                
                
                52Less:
      Loan charge-offs
                
                
                3,164
                
                
                
                453
                
                
                
                5,496
                
                
                
                984Balance
      – End of period
                
                $
                9,499
                
                
                $
                7,027
                
                
                $
                9,499
                
                
                $
                7,027





The
Company evaluates impairment of its residential mortgage and consumer loans on a
collective basis, while commercial loans are evaluated individually for
impairment.  The Company identifies a loan as impaired when it is
probable that principal and interest will not be collected according to the
contractual terms of the loan agreement.  At September 30, 2009,
management determined that impaired loans totaled $17.6 million.  Such
loans had valuation allowances totaling $2.4 million.  At December 31,
2008, management determined that impaired loans totaled $5.9
million.  These loans had valuation allowances totaling
$861,000.





The
following is a summary of nonperforming assets at the periods
presented:





September 30,
                  
                  
                  December 31,2009
                  
                  
                  2008(Dollars
      in thousands)Nonaccrual
      loans
                  
                  $
                  7,679
                  
                  
                  $
                  2,900Accruing
      loans past due 90 days or more
                  
                  
                  3,019
                  
                  
                  
                  132Total
      nonperforming loans
                  
                  
                  10,698
                  
                  
                  
                  3,032Other
      real estate owned
                  
                  
                  3,444
                  
                  
                  
                  2,601Total
      nonperforming assets
                  
                  $
                  14,142
                  
                  
                  $
                  5,633




12


The
following is a summary of nonperforming loans at the periods
presented:





September 30, 2009
                        
                        
                        December 31, 2008(Dollars
      in thousands)One-to-four
      residential permanent
                        
                        $
                        345
                        
                        
                        $
                        198Construction loans:One-to-four
      family residential owner-occupied
                        
                        
                        -
                        
                        
                        
                        -One-to-four
      family residential speculative
                        
                        
                        1,554
                        
                        
                        
                        693Commercial
                        
                        
                        -
                        
                        
                        
                        -Commercial real estate:Residential
      acquisition and development
                        
                        
                        3,510
                        
                        
                        
                        379Commercial
      land
                        
                        
                        1,884
                        
                        
                        
                        311Other
      commercial real estate
                        
                        
                        2,197
                        
                        
                        
                        748Commercial
      business
                        
                        
                        107
                        
                        
                        
                        5Consumer
                        
                        
                        1,101
                        
                        
                        
                        698Total
      nonperforming loans
                        
                        $
                        10,698
                        
                        
                        $
                        3,032





Note
8 – Commitments to Extend Credit





Commitments
to extend credit are agreements to lend as long as there is no violation of any
condition established in the contract.  Commitments generally have
fixed expiration dates or other termination clauses and may require payment of a
fee.  Since commitments may expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash
requirements.  These commitments represent no more than normal lending
risk that the Bank commits to its borrowers and management believes that these
commitments can be funded through normal
operations.   Commitments to extend credit that include both
fixed and variable rates are as follows:





September 30, 2009
                        
                        
                        December 31, 2008(Dollars
      in thousands)Loan
      commitments:Residential
      mortgage loans
                        
                        $
                        11,192
                        
                        
                        $
                        5,904Non-residential
      mortgage loans
                        
                        
                        3,373
                        
                        
                        
                        5,934Commercial
      loans
                        
                        
                        2,835
                        
                        
                        
                        457Consumer
      loans
                        
                        
                        1,868
                        
                        
                        
                        3,242Total
      loan commitments
                        
                        $
                        19,268
                        
                        
                        $
                        15,537Unused
      lines of credit:Commercial
                        
                        $
                        16,383
                        
                        
                        $
                        26,424Consumer
                        
                        
                        79,987
                        
                        
                        
                        78,872Total
      unused lines of credit
                        
                        $
                        96,370
                        
                        
                        $
                        105,296




13


Note
9 – Fair Value Measurement





The
Company utilizes fair value measurements to record fair value adjustments to
certain assets and to determine fair value disclosures.  The Company
has not elected the fair value option for liabilities.  Investment
securities, available-for-sale, are recorded at fair value on a recurring
basis.  Additionally, the Company may be required to record at fair
value other assets on a nonrecurring basis, such as impaired loans and other
real estate owned.  These nonrecurring fair value adjustments
typically involve the application of lower of cost or market accounting for
these other assets.   A fair value hierarchy is used based on the
markets in which the assets are traded and the reliability of the assumptions
used to determine the fair value.  These levels are as
follows:





Level 1: Inputs
to the valuation methodology are based on quoted prices in active markets for
identical instruments.





Level 2: Inputs
to the valuation methodology are derived from readily available pricing sources
for market transactions involving similar types of instruments in active
markets.





Level 3: Inputs
to the valuation methodology are unobservable and significant to the fair value
measurement.





Fair
value measurements for assets where there exists limited or no observable market
data and, therefore, are based primarily upon estimates, are often calculated
based on the economic and competitive environment, the characteristics of the
asset and other factors.  Therefore, the results cannot be determined
with precision and may not be realized in an actual sale or immediate settlement
of the asset or liability.  Additionally, there may be inherent
weaknesses in any calculation technique, and changes in the underlying
assumptions used, including discount rates and estimates of future cash flows,
could significantly affect the results of current or future
values.  The following is a description of valuation methodologies
used for assets recorded at fair value. The determination of where an instrument
falls in the hierarchy requires significant judgment.





Investment
Securities, Available-for-Sale–Investment securities
available-for-sale are recorded at fair value on at least a monthly
basis.  Fair value measurement is based upon quoted prices, if
available.  If quoted prices are not available, fair values are
measured using independent pricing models or other model-based valuation
techniques such as the present value of future cash flows, adjusted for the
security’s credit rating, prepayment assumptions and other factors such as
credit loss assumptions.  Level 1 fair value is used for those
securities traded on an active exchange, U.S. Treasury securities that are
traded by brokers or dealers in an active over-the-counter market, and money
market funds.  Level 2 securities include mortgage-backed securities
issued by government-sponsored enterprises, municipal bonds, and corporate debt
securities.  Securities valued using Level 3 include equity securities
that are not traded on an active exchange, investments in closely held
subsidiaries, and asset-backed securities traded in less liquid
markets.




Loans -The Company does not record loans at fair value on a recurring
basis.  However, from time to time, a loan is considered impaired and
an allowance for loan losses is established.  Loans for which it is
probable that payment of interest and principal will not be made in accordance
with the contractual terms of the loan agreement are considered
impaired.  The fair value of impaired loans is estimated using one of
several methods, including collateral value, market price and discounted cash
flows. Those impaired loans not requiring an allowance represent loans for which
the fair value of the expected repayments or collateral exceed the recorded
investments in such loans. At September 30, 2009, substantially all of the total
impaired loans were evaluated based on the fair value of the
collateral.  Impaired loans where an allowance is established based on
the fair value of collateral require classification in the fair value hierarchy.
When the fair value of the collateral is based on an observable market price or
a current appraised value, the Company records the impaired loan as nonrecurring
Level 2. When an appraised value is not available or management determines the
fair value of the collateral is further impaired below the appraised value and
there is no observable market price, the Company records the impaired loan as
nonrecurring Level 3.




Other Real Estate
Owned –Other real estate owned are adjusted to fair value upon transfer
of the loans to other real estate owned. Subsequently, these assets are carried
at the lower of carrying value or fair value.  Fair value is based
upon a current appraised value or other management estimate.  These
assets are recorded as nonrecurring Level 3.




14





Assets
Recorded at Fair Value on a Recurring Basis:





Level 1
                    
                    
                    Level 2
                    
                    
                    Level 3
                    
                    
                    Total(Dollars in thousands)September 30, 2009Investment
      securities, available-for-sale
                    
                    $
                    -
                    
                    
                    $
                    77,558
                    
                    
                    $
                    1,554
                    
                    
                    $
                    79,112Investment
      securities, held-to-maturity
                    
                    
                    -
                    
                    
                    
                    11,062
                    
                    
                    
                    -
                    
                    
                    
                    11,062





Assets
Recorded at Fair Value on a Nonrecurring Basis:





Level 1
                    
                    
                    Level 2
                    
                    
                    Level 3
                    
                    
                    Total(Dollars in thousands)September 30, 2009Impaired
      loans
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    17,558
                    
                    
                    $
                    17,558Other
      real estate owned
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    3,444
                    
                    
                    
                    3,444





Note
10 - Fair Value of Financial Instruments





The
following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments.  For cash and cash
equivalents, Federal Home Loan Bank stock, accrued interest receivable, and
accrued interest payable, fair value approximates carrying value due to their
short-term nature.  The fair value for investment securities is based
on quoted market prices, if available.  If a quoted market price is
not available, fair value is estimated using market prices for similar
securities.  Fair value for variable
rate loans that reprice frequently is based on the carrying value reduced by an
estimate of credit losses inherent in the portfolio.  Fair value for
all other loans is estimated by discounting their future cash flows using
interest rates currently being offered for loans of comparable terms and credit
quality.  Fair value for deposits with a stated maturity date (time
deposits) are estimated by discounting cash flows from expected maturities using
interest rates currently being offered for similar instruments.  The
fair value for repurchase agreements and other borrowed money is based on
discounted cash flows using current interest rates.  The fair value of
off-balance sheet financial instruments is not considered to be material, so
they are not included in the following table.  In cases where quoted
market prices are not available, fair values are based on estimates using
present value or other valuation techniques.  The estimates are
significantly affected by the assumptions used, including discount rates and
estimates of future cash flows.  These estimates may differ
substantially from amounts that could be realized in an immediate sale or
settlement of the instrument. The Company has used
management’s best estimates of fair values of financial instruments based on the
above assumptions.  This presentation does not include certain
financial instruments, nonfinancial instruments or certain intangible assets
such as customer relationships, deposit base intangibles, or
goodwill.  Accordingly, the aggregate fair value amounts presented do
not represent the underlying value of the Company.


15


The
estimated fair valuesof financial instruments
were as follows:





September 30, 2009
                
                
                December 31, 2008Carrying
                  Amount
                
                
                Estimated
                  Fair Value
                
                
                Carrying
                  Amount
                
                
                Estimated
                  Fair ValueFinancial
      assets:Cash
      and cash equivalents
                
                $
                45,496
                
                
                $
                45,496
                
                
                $
                10,057
                
                
                $
                10,057Investment
      securities
                
                
                90,174
                
                
                
                90,038
                
                
                
                109,180
                
                
                
                108,751Loans
                
                
                616,793
                
                
                
                628,829
                
                
                
                626,688
                
                
                
                639,505Accrued
      interest recevable
                
                
                2,317
                
                
                
                2,317
                
                
                
                2,609
                
                
                
                2.609Federal
      Home Loan Bank stock
                
                
                4,149
                
                
                
                4,149
                
                
                
                4,793
                
                
                
                4,793Financial
      liabilities:Deposits
                
                
                601,614
                
                
                
                592,402
                
                
                
                581,488
                
                
                
                577,876Borrowed
      money
                
                
                110,711
                
                
                
                116,811
                
                
                
                124,365
                
                
                
                128,137Accrued
      interest payable
                
                
                1,702
                
                
                
                1,702
                
                
                
                2,472
                
                
                
                2,472





Note
11 – Subsequent Events





Subsequent
events have been evaluated through November 12, 2009, which is the date the
financial statements were available to be issued.





On
October 19, 2009, the Board of Directors of the Company approved and declared a
regular cash dividend of four cents ($0.04) per share of common stock to
stockholders of record as of November 1, 2009, payable on November 15, 2009. The
Company has paid cash dividends in each of the 46 quarters since the Company’s
conversion to public ownership.





ITEM
2.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations




Forward
Looking Statements





This
report contains certain forward-looking statements that represent the Company's
expectations or beliefs concerning future events. Such forward-looking
statements are based on our current beliefs and expectations and are inherently
subject to significant business, economic, and competitive uncertainties and
contingencies, many of which are beyond our control.  These
forward-looking statements are based on assumptions with respect to future
business strategies and decisions that are subject to change based on changes in
the economic and competitive environment in which we
operate.  Forward-looking statements speak only as of the date they
are made and the Company is under no duty to update these forward-looking
statements or to reflect the occurrence of unanticipated events.  A
number of factors could cause actual conditions, events, or results to differ
significantly from those described in the forward-looking
statements.   Factors that could cause such a difference include,
but are not limited to, the timing and amount of revenues that may be recognized
by the Company, changes in local or national economic trends, increased
competition among depository and financial institutions, continuation of current
revenue and expense trends (including trends affecting chargeoffs and provisions
for loan losses), changes in interest rates, changes in the shape of the yield
curve, changes in the level of non-performing assets and charge-offs, changes in
estimates of future reserve requirements based upon the periodic review
thereof under relevant regulatory and accounting requirements, the level of
future deposit premium assessments, our ability to raise capital to fund our
growth plans or operations, the impact of the current governmental effort to
restructure the U.S. financial and regulatory system, the quality and
composition of the Company’s investment portfolio and adverse legal, regulatory
or accounting changes. Because of the risks and uncertainties inherent in
forward-looking statements, readers are cautioned not to place undue reliance on
these statements.    Readers should carefully review the
risk factors described in other documents the Company files from time to time
with the SEC, including annual reports on Form 10-K, quarterly reports on Form
10-Q, and Current Reports on Form 8-K.


16


Executive
Summary





Citizens
South Banking Corporation is a Delaware corporation that owns all of the
outstanding shares of common stock of Citizens South Bank (the
"Bank").  The Company’s principal business activities are overseeing
and directing the business of the Bank. The Company’s assets consist primarily
of the outstanding capital stock of the Bank, deposits held at the Bank, and
investment securities. The shares of common stock of the Company trade on the
Nasdaq Global Market under the ticker symbol “CSBC.”  Citizens South
Bank, which was chartered in 1904, is a federally chartered savings bank
headquartered in Gastonia, North Carolina.  The Bank’s principal
business activity is offering FDIC-insured deposits to local customers through
its 16 branch offices and investing those deposits, together with funds
generated from operations and borrowings, in residential and nonresidential real
estate loans, construction loans, commercial business loans, consumer loans,
investment securities, and mortgage-backed securities.  The Bank also
acts as a broker in both the origination of loans secured by one-to-four family
dwellings and in the sale of uninsured financial products. The Bank’s results of
operations are heavily dependent on net interest income, which is the difference
between the interest earned on loans and securities and the interest paid on
deposits and borrowings.  Results of operations are also materially
affected by the Bank’s provision for loan losses, noninterest income, and
noninterest expense.  Noninterest income includes fee income generated
from deposit and loan accounts, mortgage banking fees, increases in the cash
value of bank-owned life insurance policies, net gains (losses) from the sale of
assets and other noninterest income items.  The Bank’s noninterest
expense primarily consists of compensation and employee benefits, occupancy
expense, professional services, amortization of intangible assets, FDIC deposit
insurance premiums and other noninterest expenses.  Results of
operations are also significantly affected by local economic and competitive
conditions, changes in interest rates, and actions of regulatory and
governmental authorities.





The
following discussion is provided to assist in understanding and evaluating the
Company’s results of operations and financial condition and is designed to
provide a general overview of the Company’s performance for the three- and
nine-month periods ended September 30, 2009 and 2008.  Readers seeking
a more in-depth analysis should read the detailed discussions below, as well as
the consolidated financial statements and related notes.  Financial highlights for
the comparable periods are presented in the following
table.


17




Financial Highlights
      (unaudited)
                                                        
                                                        At
      and For the
                                                        
                                                        
                                                        At
      and For the
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        At
      and For the
                                                        
                                                        
                                                        At
      and For the(Dollars
      in thousands, except per share data)
                                                        
                                                        Three
      Months Ended
                                                        
                                                        
                                                        Three
      Months Ended
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Nine
      Months Ended
                                                        
                                                        
                                                        Nine
      Months EndedSeptember
      30, 2009
                                                        
                                                        
                                                        September
      30, 2008
                                                        
                                                        
                                                        %
      Change
                                                        
                                                        
                                                        September
      30, 2009
                                                        
                                                        
                                                        September
      30, 2008
                                                        
                                                        
                                                        %
      ChangeSummary
      Income Statement:Interest
      income
                                                        
                                                        $
                                                        9,481
                                                        
                                                        
                                                        $
                                                        10,806
                                                        
                                                        
                                                        
                                                        -12.26
                                                        %
                                                        
                                                        $
                                                        28,845
                                                        
                                                        
                                                        $
                                                        32,261
                                                        
                                                        
                                                        
                                                        -10.59
                                                        %Interest
      expense
                                                        
                                                        
                                                        3,947
                                                        
                                                        
                                                        
                                                        5,424
                                                        
                                                        
                                                        
                                                        -27.23
                                                        %
                                                        
                                                        
                                                        12,995
                                                        
                                                        
                                                        
                                                        17,180
                                                        
                                                        
                                                        
                                                        -24.36
                                                        %Net
      interest income
                                                        
                                                        
                                                        5,534
                                                        
                                                        
                                                        
                                                        5,382
                                                        
                                                        
                                                        
                                                        2.82
                                                        %
                                                        
                                                        
                                                        15,850
                                                        
                                                        
                                                        
                                                        15,081
                                                        
                                                        
                                                        
                                                        5.10
                                                        %Provision
      for loan losses
                                                        
                                                        
                                                        3,975
                                                        
                                                        
                                                        
                                                        720
                                                        
                                                        
                                                        
                                                        452.08
                                                        %
                                                        
                                                        
                                                        6,825
                                                        
                                                        
                                                        
                                                        1,815
                                                        
                                                        
                                                        
                                                        276.03
                                                        %Net
      interest income after provision for loan losses
                                                        
                                                        
                                                        1,559
                                                        
                                                        
                                                        
                                                        4,662
                                                        
                                                        
                                                        
                                                        -66.56
                                                        %
                                                        
                                                        
                                                        9,025
                                                        
                                                        
                                                        
                                                        13,266
                                                        
                                                        
                                                        
                                                        -31.97
                                                        %Noninterest
      income
                                                        
                                                        
                                                        2,501
                                                        
                                                        
                                                        
                                                        1,492
                                                        
                                                        
                                                        
                                                        67.63
                                                        %
                                                        
                                                        
                                                        5,766
                                                        
                                                        
                                                        
                                                        4,765
                                                        
                                                        
                                                        
                                                        21.01
                                                        %Noninterest
      expense
                                                        
                                                        
                                                        5,229
                                                        
                                                        
                                                        
                                                        5,145
                                                        
                                                        
                                                        
                                                        1.63
                                                        %
                                                        
                                                        
                                                        15,405
                                                        
                                                        
                                                        
                                                        14,730
                                                        
                                                        
                                                        
                                                        4.58
                                                        %Net
      income (loss) before income taxes
                                                        
                                                        
                                                        (1,169
                                                        )
                                                        
                                                        
                                                        1,009
                                                        
                                                        
                                                        
                                                        -215.86
                                                        %
                                                        
                                                        
                                                        (614
                                                        )
                                                        
                                                        
                                                        3,301
                                                        
                                                        
                                                        
                                                        -118.60
                                                        %Income
      tax expense (benefit)
                                                        
                                                        
                                                        (672
                                                        )
                                                        
                                                        
                                                        187
                                                        
                                                        
                                                        
                                                        -459.36
                                                        %
                                                        
                                                        
                                                        (887
                                                        )
                                                        
                                                        
                                                        647
                                                        
                                                        
                                                        
                                                        -237.09
                                                        %Net
      income (loss)
                                                        
                                                        
                                                        (497
                                                        )
                                                        
                                                        
                                                        822
                                                        
                                                        
                                                        
                                                        -160.46
                                                        %
                                                        
                                                        
                                                        273
                                                        
                                                        
                                                        
                                                        2,654
                                                        
                                                        
                                                        
                                                        -89.71
                                                        %Dividends
      on preferred stock
                                                        
                                                        
                                                        262
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        NM
                                                        
                                                        
                                                        
                                                        774
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        NMNet
      income available to common stockholders
                                                        
                                                        $
                                                        (759
                                                        )
                                                        
                                                        $
                                                        822
                                                        
                                                        
                                                        
                                                        -192.34
                                                        %
                                                        
                                                        $
                                                        (501
                                                        )
                                                        
                                                        $
                                                        2,654
                                                        
                                                        
                                                        
                                                        -118.88
                                                        %Per
      Common Share Data:Earnings
      (loss):Basic
                                                        
                                                        $
                                                        (0.10
                                                        )
                                                        
                                                        $
                                                        0.11
                                                        
                                                        
                                                        
                                                        -190.91
                                                        %
                                                        
                                                        $
                                                        (0.07
                                                        )
                                                        
                                                        $
                                                        0.36
                                                        
                                                        
                                                        
                                                        -119.44
                                                        %Diluted
                                                        
                                                        
                                                        (0.10
                                                        )
                                                        
                                                        
                                                        0.11
                                                        
                                                        
                                                        
                                                        -190.91
                                                        %
                                                        
                                                        
                                                        (0.07
                                                        )
                                                        
                                                        
                                                        0.36
                                                        
                                                        
                                                        
                                                        -119.44
                                                        %Weighted
      average shares:Basic
                                                        
                                                        
                                                        7,419,206
                                                        
                                                        
                                                        
                                                        7,358,086
                                                        
                                                        
                                                        
                                                        0.83
                                                        %
                                                        
                                                        
                                                        7,405,199
                                                        
                                                        
                                                        
                                                        7,380,236
                                                        
                                                        
                                                        
                                                        0.34
                                                        %Diluted
                                                        
                                                        
                                                        7,419,206
                                                        
                                                        
                                                        
                                                        7,386,513
                                                        
                                                        
                                                        
                                                        0.44
                                                        %
                                                        
                                                        
                                                        7,405,199
                                                        
                                                        
                                                        
                                                        7,414,274
                                                        
                                                        
                                                        
                                                        -0.12
                                                        %End
      of period shares outstanding
                                                        
                                                        
                                                        7,526,854
                                                        
                                                        
                                                        
                                                        7,516,816
                                                        
                                                        
                                                        
                                                        0.13
                                                        %
                                                        
                                                        
                                                        7,526,854
                                                        
                                                        
                                                        
                                                        7,516,816
                                                        
                                                        
                                                        
                                                        0.13
                                                        %Cash
      dividends paid
                                                        
                                                        $
                                                        0.040
                                                        
                                                        
                                                        $
                                                        0.085
                                                        
                                                        
                                                        
                                                        -52.94
                                                        %
                                                        
                                                        $
                                                        0.165
                                                        
                                                        
                                                        $
                                                        0.250
                                                        
                                                        
                                                        
                                                        -34.00
                                                        %Book
      value
                                                        
                                                        
                                                        11.08
                                                        
                                                        
                                                        
                                                        11.02
                                                        
                                                        
                                                        
                                                        0.54
                                                        %
                                                        
                                                        
                                                        11.08
                                                        
                                                        
                                                        
                                                        11.02
                                                        
                                                        
                                                        
                                                        0.54
                                                        %Tangible
      book value
                                                        
                                                        
                                                        7.06
                                                        
                                                        
                                                        
                                                        6.84
                                                        
                                                        
                                                        
                                                        3.22
                                                        %
                                                        
                                                        
                                                        7.06
                                                        
                                                        
                                                        
                                                        6.84
                                                        
                                                        
                                                        
                                                        3.22
                                                        %End
      of Period Balances:Total
      assets
                                                        
                                                        $
                                                        820,608
                                                        
                                                        
                                                        $
                                                        823,030
                                                        
                                                        
                                                        
                                                        -0.29
                                                        %
                                                        
                                                        $
                                                        820,608
                                                        
                                                        
                                                        $
                                                        823,030
                                                        
                                                        
                                                        
                                                        -0.29
                                                        %Loans,
      net of deferred fees
                                                        
                                                        
                                                        616,793
                                                        
                                                        
                                                        
                                                        628,496
                                                        
                                                        
                                                        
                                                        -1.86
                                                        %
                                                        
                                                        
                                                        616,793
                                                        
                                                        
                                                        
                                                        628,496
                                                        
                                                        
                                                        
                                                        -1.86
                                                        %Investment
      securities
                                                        
                                                        
                                                        90,174
                                                        
                                                        
                                                        
                                                        107,522
                                                        
                                                        
                                                        
                                                        -16.13
                                                        %
                                                        
                                                        
                                                        90,174
                                                        
                                                        
                                                        
                                                        107,522
                                                        
                                                        
                                                        
                                                        -16.13
                                                        %Interest-earning
      assets
                                                        
                                                        
                                                        734,938
                                                        
                                                        
                                                        
                                                        732,683
                                                        
                                                        
                                                        
                                                        0.31
                                                        %
                                                        
                                                        
                                                        734,938
                                                        
                                                        
                                                        
                                                        732,683
                                                        
                                                        
                                                        
                                                        0.31
                                                        %Deposits
                                                        
                                                        
                                                        601,614
                                                        
                                                        
                                                        
                                                        584,928
                                                        
                                                        
                                                        
                                                        2.85
                                                        %
                                                        
                                                        
                                                        601,614
                                                        
                                                        
                                                        
                                                        584,928
                                                        
                                                        
                                                        
                                                        2.85
                                                        %Stockholders'
      equity
                                                        
                                                        
                                                        103,990
                                                        
                                                        
                                                        
                                                        82,827
                                                        
                                                        
                                                        
                                                        25.55
                                                        %
                                                        
                                                        
                                                        103,990
                                                        
                                                        
                                                        
                                                        82,827
                                                        
                                                        
                                                        
                                                        25.55
                                                        %Average
      Balances:Total
      assets
                                                        
                                                        $
                                                        831,268
                                                        
                                                        
                                                        $
                                                        817,613
                                                        
                                                        
                                                        
                                                        1.67
                                                        %
                                                        
                                                        $
                                                        831,934
                                                        
                                                        
                                                        $
                                                        794,066
                                                        
                                                        
                                                        
                                                        4.77
                                                        %Loans,
      net of deferred fees
                                                        
                                                        
                                                        624,112
                                                        
                                                        
                                                        
                                                        615,755
                                                        
                                                        
                                                        
                                                        1.36
                                                        %
                                                        
                                                        
                                                        628,826
                                                        
                                                        
                                                        
                                                        590,554
                                                        
                                                        
                                                        
                                                        6.48
                                                        %Investment
      securities
                                                        
                                                        
                                                        94,674
                                                        
                                                        
                                                        
                                                        116,269
                                                        
                                                        
                                                        
                                                        -18.57
                                                        %
                                                        
                                                        
                                                        104,096
                                                        
                                                        
                                                        
                                                        113,140
                                                        
                                                        
                                                        
                                                        -7.99
                                                        %Interest-earning
      assets
                                                        
                                                        
                                                        741,974
                                                        
                                                        
                                                        
                                                        724,949
                                                        
                                                        
                                                        
                                                        2.35
                                                        %
                                                        
                                                        
                                                        744,586
                                                        
                                                        
                                                        
                                                        700,225
                                                        
                                                        
                                                        
                                                        6.34
                                                        %Deposits
                                                        
                                                        
                                                        609,243
                                                        
                                                        
                                                        
                                                        581,162
                                                        
                                                        
                                                        
                                                        4.83
                                                        %
                                                        
                                                        
                                                        606,446
                                                        
                                                        
                                                        
                                                        579,810
                                                        
                                                        
                                                        
                                                        4.59
                                                        %Stockholders'
      equity
                                                        
                                                        
                                                        103,913
                                                        
                                                        
                                                        
                                                        82,478
                                                        
                                                        
                                                        
                                                        25.99
                                                        %
                                                        
                                                        
                                                        104,562
                                                        
                                                        
                                                        
                                                        83,685
                                                        
                                                        
                                                        
                                                        24.95
                                                        %Financial
      Performance Ratios:Return
      on average assets
                                                        
                                                        
                                                        -0.36
                                                        %
                                                        
                                                        
                                                        0.40
                                                        %
                                                        
                                                        
                                                        -190.00
                                                        %
                                                        
                                                        
                                                        -0.08
                                                        %
                                                        
                                                        
                                                        0.45
                                                        %
                                                        
                                                        
                                                        -117.78
                                                        %Return
      on avg common shareholders' equity
                                                        
                                                        
                                                        -3.61
                                                        %
                                                        
                                                        
                                                        3.97
                                                        %
                                                        
                                                        
                                                        -190.93
                                                        %
                                                        
                                                        
                                                        -0.80
                                                        %
                                                        
                                                        
                                                        4.25
                                                        %
                                                        
                                                        
                                                        -118.82
                                                        %Noninterest
      income to average assets
                                                        
                                                        
                                                        1.20
                                                        %
                                                        
                                                        
                                                        0.73
                                                        %
                                                        
                                                        
                                                        64.87
                                                        %
                                                        
                                                        
                                                        0.92
                                                        %
                                                        
                                                        
                                                        0.80
                                                        %
                                                        
                                                        
                                                        15.50
                                                        %Noninterest
      expense to average assets
                                                        
                                                        
                                                        2.52
                                                        %
                                                        
                                                        
                                                        2.52
                                                        %
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        2.47
                                                        %
                                                        
                                                        
                                                        2.47
                                                        %
                                                        
                                                        
                                                        -Efficiency
      ratio
                                                        
                                                        
                                                        65.08
                                                        %
                                                        
                                                        
                                                        74.85
                                                        %
                                                        
                                                        
                                                        -13.05
                                                        %
                                                        
                                                        
                                                        71.30
                                                        %
                                                        
                                                        
                                                        74.22
                                                        %
                                                        
                                                        
                                                        -3.93
                                                        %Net
      Interest Spread / Margin:Yield
      on earning assets
                                                        
                                                        
                                                        5.13
                                                        %
                                                        
                                                        
                                                        5.99
                                                        %
                                                        
                                                        
                                                        -14.36
                                                        %
                                                        
                                                        
                                                        5.25
                                                        %
                                                        
                                                        
                                                        6.22
                                                        %
                                                        
                                                        
                                                        -15.59
                                                        %Cost
      of funds
                                                        
                                                        
                                                        2.30
                                                        %
                                                        
                                                        
                                                        3.13
                                                        %
                                                        
                                                        
                                                        -26.52
                                                        %
                                                        
                                                        
                                                        2.58
                                                        %
                                                        
                                                        
                                                        3.48
                                                        %
                                                        
                                                        
                                                        -25.86
                                                        %Interest
      rate spread
                                                        
                                                        
                                                        2.83
                                                        %
                                                        
                                                        
                                                        2.86
                                                        %
                                                        
                                                        
                                                        -1.05
                                                        %
                                                        
                                                        
                                                        2.67
                                                        %
                                                        
                                                        
                                                        2.74
                                                        %
                                                        
                                                        
                                                        -2.55
                                                        %Net
      interest margin - tax equivalent
      (1)
                                                        
                                                        
                                                        3.03
                                                        %
                                                        
                                                        
                                                        3.02
                                                        %
                                                        
                                                        
                                                        0.33
                                                        %
                                                        
                                                        
                                                        2.92
                                                        %
                                                        
                                                        
                                                        2.96
                                                        %
                                                        
                                                        
                                                        -1.35
                                                        %Credit
      Quality Data:Allowance
      for loan losses
                                                        
                                                        
                                                        9,499
                                                        
                                                        
                                                        
                                                        7,027
                                                        
                                                        
                                                        
                                                        35.18
                                                        %
                                                        
                                                        
                                                        9,499
                                                        
                                                        
                                                        
                                                        7,027
                                                        
                                                        
                                                        
                                                        35.18
                                                        %Net
      charge-offs
                                                        
                                                        
                                                        3,161
                                                        
                                                        
                                                        
                                                        450
                                                        
                                                        
                                                        
                                                        602.44
                                                        %
                                                        
                                                        
                                                        5,352
                                                        
                                                        
                                                        
                                                        932
                                                        
                                                        
                                                        
                                                        474.25
                                                        %Nonperforming
      loans (NPL's)
                                                        
                                                        $
                                                        10,698
                                                        
                                                        
                                                        $
                                                        3,335
                                                        
                                                        
                                                        
                                                        220.78
                                                        %
                                                        
                                                        $
                                                        10,698
                                                        
                                                        
                                                        $
                                                        3,335
                                                        
                                                        
                                                        
                                                        220.78
                                                        %Other
      real estate owned (OREO)
                                                        
                                                        
                                                        3,444
                                                        
                                                        
                                                        
                                                        1,214
                                                        
                                                        
                                                        
                                                        183.69
                                                        %
                                                        
                                                        
                                                        3,444
                                                        
                                                        
                                                        
                                                        1,214
                                                        
                                                        
                                                        
                                                        183.69
                                                        %Nonperforming
      assets (NPA's)
                                                        
                                                        
                                                        14,142
                                                        
                                                        
                                                        
                                                        4,549
                                                        
                                                        
                                                        
                                                        210.88
                                                        %
                                                        
                                                        
                                                        14,142
                                                        
                                                        
                                                        
                                                        4,549
                                                        
                                                        
                                                        
                                                        210.88
                                                        %ALLL
      to total loans
                                                        
                                                        
                                                        1.54
                                                        %
                                                        
                                                        
                                                        1.12
                                                        %
                                                        
                                                        
                                                        37.74
                                                        %
                                                        
                                                        
                                                        1.54
                                                        %
                                                        
                                                        
                                                        1.12
                                                        %
                                                        
                                                        
                                                        37.74
                                                        %Net
      charge-offs to average loans (annualized)
                                                        
                                                        
                                                        2.03
                                                        %
                                                        
                                                        
                                                        0.29
                                                        %
                                                        
                                                        
                                                        593.04
                                                        %
                                                        
                                                        
                                                        1.16
                                                        %
                                                        
                                                        
                                                        0.20
                                                        %
                                                        
                                                        
                                                        485.14
                                                        %NPL's
      to total loans
                                                        
                                                        
                                                        1.73
                                                        %
                                                        
                                                        
                                                        0.53
                                                        %
                                                        
                                                        
                                                        226.87
                                                        %
                                                        
                                                        
                                                        1.73
                                                        %
                                                        
                                                        
                                                        0.53
                                                        %
                                                        
                                                        
                                                        226.87
                                                        %NPA's
      to total assets
                                                        
                                                        
                                                        1.72
                                                        %
                                                        
                                                        
                                                        0.55
                                                        %
                                                        
                                                        
                                                        211.80
                                                        %
                                                        
                                                        
                                                        1.72
                                                        %
                                                        
                                                        
                                                        0.55
                                                        %
                                                        
                                                        
                                                        211.80
                                                        %NPA's
      to total loans & OREO
                                                        
                                                        
                                                        2.28
                                                        %
                                                        
                                                        
                                                        0.72
                                                        %
                                                        
                                                        
                                                        215.63
                                                        %
                                                        
                                                        
                                                        2.28
                                                        %
                                                        
                                                        
                                                        0.72
                                                        %
                                                        
                                                        
                                                        215.63
                                                        %Capital
      Ratios:Tangible
      common equity
                                                        
                                                        
                                                        6.72
                                                        %
                                                        
                                                        
                                                        6.59
                                                        %
                                                        
                                                        
                                                        1.97
                                                        %
                                                        
                                                        
                                                        6.72
                                                        %
                                                        
                                                        
                                                        6.59
                                                        %
                                                        
                                                        
                                                        1.97
                                                        %Bank-only
      regulatory capital ratios:Tier
      1
                                                        
                                                        
                                                        10.53
                                                        %
                                                        
                                                        
                                                        8.41
                                                        %
                                                        
                                                        
                                                        25.21
                                                        %
                                                        
                                                        
                                                        10.53
                                                        %
                                                        
                                                        
                                                        8.41
                                                        %
                                                        
                                                        
                                                        25.21
                                                        %Total
      risk-based
                                                        
                                                        
                                                        14.41
                                                        %
                                                        
                                                        
                                                        10.79
                                                        %
                                                        
                                                        
                                                        33.55
                                                        %
                                                        
                                                        
                                                        14.41
                                                        %
                                                        
                                                        
                                                        10.79
                                                        %
                                                        
                                                        
                                                        33.55
                                                        %Tier
      1 risk-based
                                                        
                                                        
                                                        13.26
                                                        %
                                                        
                                                        
                                                        9.76
                                                        %
                                                        
                                                        
                                                        35.86
                                                        %
                                                        
                                                        
                                                        13.26
                                                        %
                                                        
                                                        
                                                        9.76
                                                        %
                                                        
                                                        
                                                        35.86
                                                        %Tangible
      equity
                                                        
                                                        
                                                        10.53
                                                        %
                                                        
                                                        
                                                        8.41
                                                        %
                                                        
                                                        
                                                        25.21
                                                        %
                                                        
                                                        
                                                        10.53
                                                        %
                                                        
                                                        
                                                        8.41
                                                        %
                                                        
                                                        
                                                        25.21
                                                        %
  NM = Not
meaingful
 (1)
Includes tax equivalent adjustments of $139,000, 136,000, $425,000 and $394,000
for the three months ended September 30, 2009 and 2008 and the nine months ended
September 30, 2009 and
2008, respectively.


18


Critical
Accounting Policies





The
accounting and financial policies of the Company and its subsidiaries are
prepared in accordance with accounting principles generally accepted in the
United States and conform to general practices in the banking
industry.  We consider accounting policies that require significant
judgment and assumptions by management that have, or could have, a material
impact on the carrying value of certain assets or on income to be critical
accounting policies.  Changes in underlying factors, assumptions or
estimates could have a material impact on our future financial condition and
results of operations.  Based on the size of the item or significance
of the estimate, the following accounting policies are considered critical to
our financial results.





Allowance for Loan
Losses.The allowance for loan losses is calculated with the
objective of maintaining an allowance sufficient to absorb estimated probable
loan losses inherent in the Bank’s portfolio at the measurement date.
Management’s determination of the adequacy of the allowance is based on
quarterly evaluations of the loan portfolio and other relevant
factors.  However, this evaluation is inherently subjective, as it
requires an estimate of the loss for each type of loan and for each impaired
loan, an estimate of the amounts and timing of expected future cash flows, and
an estimate of the value of the collateral. Management has established a
systematic method for periodically evaluating the credit quality of the loan
portfolio in order to establish an allowance for loan losses.  The
methodology is set forth in a formal policy and includes a review of all loans
in the portfolio on which full collectability may or may not be reasonably
assured.  The loan review considers among other matters, the estimated
fair value of the collateral, economic conditions, historical loan loss
experience, our knowledge of inherent losses in the portfolio that are probable
and reasonably estimable and other factors that warrant recognition in providing
an appropriate loan loss allowance.  Specific allowances are
established for certain individual loans that management considers
impaired.  The remainder of the portfolio is segmented into groups of
loans with similar risk characteristics for evaluation and
analysis.  In originating loans, we recognize that losses will be
experienced and that the risk of loss will vary with, among other things, the
type of loan being made, the creditworthiness of the borrower, the term of the
loan, general economic conditions, and in the case of a secured loan, the
quality of the collateral.  We increase our allowance for loan losses
by charging provisions for loan losses against our current period
income.  Management’s periodic evaluation of the adequacy of the
allowance is consistently applied and is based on our past loan loss experience,
particular risks inherent in the different kinds of lending that we engage in,
adverse situations that may affect the borrower’s ability to repay, the
estimated value of any underlying collateral, current economic conditions, and
other relevant internal and external factors that affect loan
collectability.  Management believes this is a critical accounting
policy because this evaluation involves a high degree of complexity and requires
us to make subjective judgments that often require assumptions or estimates
about various matters.





Other-Than-Temporary Impairment of
Securities.On at least a quarterly basis management reviews
all investment securities with significant declines in fair value for potential
other-than-temporary impairment.  Effective September 30, 2009,
management evaluated the Company’s investment portfolio and determined that a
$333,000 impairment on a $1.0 million trust preferred collateralized debt
obligation was other-than-temporary.  Management had previously
determined that the $468,000 impairment on this security as of September 30,
2008, was other-than-temporary.  These impairments have reduced the
carrying balance on this security to $241,000.  This investment is
collateralized by trust preferred securities that were issued by a pool of 40
banks operating throughout the country.  Management determined that
the impairment was other-than-temporary because 1) eight of the original 40
banks had defaulted or deferred on their payments; 2) the security, which had an
original credit rating of “A-”, had been downgraded to “C”; and 3) the interest
rate of LIBOR plus 105 basis points on this security was well below the current
pricing for current bank capital.  Management determined that it was
unlikely that the pricing for bank capital would return to a level consistent
with the pricing on the Company’s security in the foreseeable
future.  The fair value was prepared using a discounted cash flow
model using a 15% discount rate.  The Company uses valuation
techniques that it believes are appropriate and which are consistently
applied.  A fair value hierarchy is used to prioritize valuation
inputs into the following three levels to determine fair value:





Level
1:  Quoted prices in active markets for identical assets or
liabilities.


Level
2:  Observable inputs other than the quoted prices included in
Level 1.


Level
3:  Unobservable inputs.


19





Due to
the lack of liquidity in this equity investment, the security was valued using
Level 3.





Effective
September 30, 2009, management evaluated the Company’s investment portfolio and
determined that all other unrealized losses were the direct result of temporary
changes in interest rates and that such losses may be recovered in the
foreseeable future.  The Company has the ability to hold these
investments to maturity if necessary in order to recover any temporary losses
that may presently exist.  As a result, management did not consider
any additional unrealized losses as “other-than-temporary” as of September 30,
2009.





Comparison
of Financial Condition





Assets.  Total assets of
the Company increased by $3.4 million, or 0.4%, from $817.2 million at December
31, 2008, to $820.6 million at September 30, 2009.  This increase was
primarily due to a $35.0 million increase in interest-earning bank balances,
which was partly offset by a $19.0 million decrease in total investment
securities, a $9.9 million decrease in loans and a $1.5 million decrease in
premises and equipment.





Interest-earning
bank balances, which include the Bank’s deposits at the Federal Reserve Bank,
increased by $35.0 million from $613,000 at December 31, 2008, to $35.6 million
at September 30, 2009.  This increase was primarily attributable to
excess cash generated by deposit growth of $20.1 million, a $9.9 million
decrease in loans and a $19.0 million decrease in total investment
securities.  These increases in interest-earning bank balances were
partly offset by a $13.7 million decrease in borrowed
money.   Management expects that the level of interest-bearing
bank balances will be substantially reduced in the first half of 2010 as this
excess liquidity is invested in loans and investment securities.





During
the nine-month period ended September 30, 2009, loans receivable decreased by
$9.9 million, or 1.6%, to $616.8 million.  This decrease in loans was
primarily due to a $17.4 million, or 50.4%, decrease in one-to-four family
speculative construction loans, a $21.9 million, or 65.5%, decrease in
commercial construction loans, and a $13.0 million, or 34.4%, decrease in
residential acquisition and development loans.  One-to-four family
speculative construction loans decreased to $17.1 million due to reduced demand
during the period. Also, the Company created a new mortgage loan program for
these speculative construction loans which is available only to qualified
borrowers purchasing new owner-occupied residential properties.  This
program offers loans with an attractive interest rate over a 30-year
amortization period and no origination fees. The total amount of loans that were
financed under this program was $7.2 million at September 30,
2009.  Commercial construction loans decreased to $11.6 million
primarily due to the conversion of several larger commercial projects from
construction status to permanent status during the period, a decrease in local
loan demand and a reduced interest by the Company in these types of
loans.  The decrease in residential acquisition and development loans
to $40.3 million was primarily due to decreased originations of new projects and
sales of lots in existing projects.





The
decreases in construction and residential acquisition and development loans were
partly offset by a $35.0 million, or 15.4%, increase in other commercial real
estate loans, a $5.4 million, or 15.6%, increase in commercial business loans, a
$1.3 million, or 3.3% increase in commercial land loans, and a $2.4 million, or
2.1%, increase in consumer loans.  The Company’s growth in other
commercial real estate loans to $260.9 million has been diversified and includes
collateral such as investment and owner-occupied office space, retail properties
that include a credit tenant, investment retail, and
industrial.  Commercial business loans have increased to $39.8 million
primarily due to the Company’s expansion into the Charlotte market during the
year and an increased focus on developing complete banking relationships with
operating companies. The slight increases in commercial land loans to $41.8
million and consumer loans to $116.7 million was due to normal lending activity
during the period.





While the
economy in the Charlotte region has generally outperformed most other large
metropolitan areas of the country during the ongoing economic slowdown, the
economy in the Charlotte region continued to slow during 2009.  As a
result, the Company’s loan production slowed to $104.2 million during the first
nine months of 2009 as compared to $216.1 million during the first nine months
of 2008.    A continued slowdown in the local economy would
have a negative impact on the Company’s ability to generate loan growth.
Management will seek to grow the loan portfolio in a prudent manner with an
emphasis on borrowers that have a demonstrated capacity to meet their debt
obligations, even if the local economy continues to slow.


20





During
the nine-month period ended September 30, 2009, investment securities decreased
by $19.0 million, or 17.4%, to $90.2 million.  The decrease was
primarily due to the sale of $48.0 million of investment securities and the
normal maturities and principal amortization of $15.9 million.  Also,
during the period, the Company purchased $43.3 million of investments
securities.  The sales of investment securities during the period were
primarily due to a restructuring of the investment portfolio in an effort to
reduce potential interest rate risk in a rising interest rate
environment.  Management expects the investment portfolio to decrease
as a percentage of total assets over the next 12 months as the Bank’s excess
liquidity is invested in higher-yielding assets.





Other
real estate owned, which includes all properties acquired by the Company through
foreclosure, totaled $3.4 million at September 30, 2009, compared to $2.6
million at December 31, 2008.   At September 30, 2009, other real
estate owned consisted of 13 one-to-four family residential dwellings, 22
residential lots, one parcel of commercial land, and one commercial office
building.  During the first nine months of 2009, the Company
foreclosed on 21 residential lots, nine residential properties, one parcel of
commercial land and one commercial office building.  Also, during the
same period, the Company sold eight foreclosed residential properties and one
foreclosed commercial property for a net loss of $263,000 and reduced the book
value of two additional properties by $175,000 due to a drop in real estate
prices for comparable properties.  All foreclosed properties are
written down to their estimated fair value (market value less estimated
disposition costs) at acquisition and are located in the Bank’s primary lending
area.  Management will continue to aggressively market foreclosed
properties for a timely disposition.





Premises
and equipment decreased by $1.5 million, or 8.7%, to $15.4 million at September
30, 2009.  This decrease was primarily due to the sale of a branch
site for $809,000 and normal depreciation.  During the third quarter
of 2009, the Company sold its branch site in Indian Trail, North Carolina in a
sale leaseback transaction.  A full-service office will be constructed
on the site and the Bank is expected to occupy the office in the first quarter
of 2010.  This new office will replace an existing full-service leased
office located near the new site.  Also, during the third quarter of
2009, the Company transitioned a loan production office located in a leased
facility in Charlotte, North Carolina into a full-service branch which focuses
on servicing commercial customers.  Finally, in the fourth quarter of
2009, the Company plans to transition its Downtown Gastonia full-service branch
office into a commercial servicing branch and an expanded operations
center.  No other significant changes to the Company’s premises and
equipment are anticipated for the remainder of 2009.





As of
September 30, 2009, the Company had a $1.8 million deferred tax
asset.  Management believes that the Company will generate an adequate
level of earnings in the future in order to maintain the deferred tax asset on
the Company’s books.





Liabilities.Total liabilities increased
by $4.1 million, or 0.6%, from $712.5 million at December 31, 2008, to $716.6
million at September 30, 2009.  This increase was primarily due to a
$20.1 million increase in total deposits, which was partly offset by a $13.7
million decrease in borrowed money.





During
the first nine months of 2009, total deposits increased by $20.1 million, or
3.5%, to $601.6 million at September 30, 2009. This increase in deposits was
fueled in part by positive publicity that the Company received relating to our
nationally recognized program for utilization of funds received from the U.S.
Treasury CPP for low interest mortgage loans.  The Company’s low
interest rate mortgage program was featured in an article in The Washington Post and was
subsequently covered by several other nationally recognized print and electronic
media organizations. Our deposit growth was also partly due to a flight to
safety as funds moved from weaker financial institutions and brokerage accounts
as well as a continued emphasis on increasing the Company’s number of retail and
business customers through employee incentive plans and enhanced treasury
service products.  During the first nine months of 2009 demand
deposits (checking accounts) increased by $25.1 million, or 20.4%, to $147.8
million, money market deposit accounts increased by $12.5 million, or 12.1%, to
$115.7 million, and savings accounts increased by $291,000, or 2.7%, to $11.0
million. Time deposits decreased $17.7 million during the nine-month
period.  This decrease was primarily due to some above-market pricing
by some local competitors.  The Company will continue to actively
market the Company’s deposit products at pricing points that management believes
to be profitable. Management has always focused on increasing deposits by
building customer relationships and typically avoids growing deposits by
offering the highest rates in the market.   While the Company
does not actively solicit or obtain brokered deposits, this is an alternative
funding source that may be used from time to time for additional loan growth or
liquidity needs. At September 30, 2009, brokered deposits totaled
$99,000.


21





Borrowed
money decreased by $13.7 million, or 11.0%, to $110.7 million from December 31,
2008 to September 30, 2009.  This decrease was primarily due to the
repayment of short-term Federal Home Loan Bank (“FHLB”) advances that were
obtained primarily for the purpose of funding loan growth.  Funds
generated from growth in deposits were used to repay these short-term FHLB
advances.  Additional borrowed money may be used in the future to fund
additional loan growth, or purchase investment or mortgage-backed
securities.





Stockholders’
Equity.Total
stockholders’ equity decreased by $730,000, or 0.7%, from $104.7 million at
December 31, 2008, to $104.0 million at September 30, 2009.  During
the first nine months of 2009, the Company paid $1.2 million in dividends on
common stock and incurred a net loss of $501,000.  These decreases in
capital were partly offset by a $539,000 increase in the unrealized gain on
available-for-sale securities.  The increase in unrealized gains on
available-for-sale securities was primarily due to decreases in market interest
rates during the period which resulted in higher market values for these
securities.





Comparison
of Results of Operations for the Three Months Ended September 30, 2009 and
2008





General.  Net loss
available to common stockholders for the three months ended September 30, 2009,
amounted to $759,000, or $0.10 per diluted share, as compared to net income of
$822,000, or $0.11 per diluted share, for the three months ended September 30,
2008.  This change was largely due to a $3.3 million increase in the
loan loss provision arising as a result of a slowing local
economy.  Also, during the quarter ended September 30, 2009, the
Company paid $262,000 in dividends on $20.5 million of preferred stock issued by
the U.S. Treasury, as compared to no preferred dividend payments during the
quarter ended September 30, 2008.





Net interest
income.
Interest income decreased by $1.3 million, or 12.3%, to $9.5 million for the
third quarter of 2009, primarily as a result of a 400 basis point decrease in
short-term market interest rates during 2008.  With approximately 46%
of the Company’s loan portfolio scheduled to reprice on a monthly basis, the
Company’s average yield on earning assets decreased by 86 basis points over the
comparable periods to 5.13% for the quarter ended September 30, 2009. The
Company was able to offset some of the negative effects of this decrease in
yield through asset growth.  Average interest-earning assets increased
by $17.0 million, or 2.4%, to $742.0 million for the three months ended
September 30, 2009. The increase in average interest-earning assets was
primarily the result of an $8.3 million, or 1.4%, increase in average
outstanding loans to $624.1 million for the 2009 quarter.





Interest
expense decreased by $1.5 million, or 27.2%, for the comparable periods to $3.9
million for the third quarter of 2009.  This decrease in interest
expense was largely due to lower market interest rates, which resulted in an 83
basis point decrease in the average cost of funds to 2.30% for the quarter ended
September 30, 2009.  In addition, to the lower cost of funds, the
Company’s average interest-bearing liabilities decreased by $7.9 million, or
1.1%, to $677.9 million for the three months ended September 30, 2009. Average
interest-bearing liabilities decreased primarily as a result of a $34.7 million,
or 23.9%, decrease in average interest-bearing borrowings, which was partly
offset by a $26.8 million, or 5.0%, increase in average interest-bearing
deposits.





The
Company’s net interest margin increased by one basis point to 3.03% for the
quarter ended September 30, 2009, compared to 3.02% for the quarter ended
September 30, 2008.  This slight increase in the net interest margin
was the result of the cost of funds falling at a faster rate than the yield on
assets. On a linked-quarter basis, the Company’s net interest margin increased
11 basis points from 2.92% for the second quarter of 2009 to 3.03% for the third
quarter of 2009.  While the Company maintains a relatively neutral
interest rate risk position on a cumulative one-year basis, the Federal Reserve
Board’s action to lower short-term interest rates by 200 basis points in the
fourth quarter of 2008 had a more pronounced negative impact in the first three
months following the decrease.  The short-term negative effects of
this decrease in short-term interest rates have been mostly offset by time
deposits that matured over the next 12 months and repriced at a lower cost to
the Company.


22





Provision for
loan losses.Due to the general weakness in the local economy
and an increase in nonperforming assets, the Company increased its provision for
loan losses to $4.0 million for the third quarter of 2009 compared to $720,000
for the third quarter of 2008.  As a result, the allowance for loan
losses was $9.5 million, or 1.54% of total loans, as of September 30, 2009,
compared to $7.0 million, or 1.12% of total loans, as of September 30,
2008.  While the Company’s credit quality continues to compare
favorably with industry peers, the continued decline in local economic
conditions has resulted in an upward trend in the Company’s loan delinquency
ratios.   The Company’s ratio of non-performing assets to total
assets increased from 0.53% at September 30, 2008, to 1.73% at September 30,
2009. A substantial portion of the Company’s nonperforming loans at September
30, 2009, was secured by real estate located in the Company’s normal lending
market.  Net chargeoffs, annualized, totaled $3.2 million, or 2.04% of
average loans, during the third quarter of 2009 compared to $1.2 million, or
0.28% of average loans, during the third quarter of 2008. Based on a recent
review of the Company’s loan portfolio by the Bank’s federal regulator and minor
improvements in the local economy, management believes that its problem loans
are manageable.  However, management expects that the Company will
continue to experience larger than normal loan loss provisions over the
foreseeable future.




Noninterest
income.Noninterest
income increased by $1.0 million, or 67.6%, to $2.5 million for the three months
ended September 30, 2009, as compared to $1.5 million for the three months ended
September 30, 2008. This increase was largely attributable to a $939,000
increase in the net gain on sale of assets during the comparable
periods.  During the third quarter of 2009 the Company sold four
residential properties that were acquired through foreclosure at a net loss of
$19,000 and $27.3 million in investment securities for a net gain of
$973,000.  The Company also sold a parcel of land to be leased as a
future branch office at a loss of $2,000.  During the third quarter of
2008 the Company recognized a $1,000 net gain on the sale of $5.8 million in
investment securities, a $6,000 gain on the sale of $112,000 in real estate
owned, and a $6,000 gain on the sale of $15,000 in miscellaneous fixed
assets.





The
remainder of the increase in noninterest income was primarily due to a $57,000
increase in fees on deposits, a $46,000 increase in mortgage banking fee income,
and a $48,000 increase in other noninterest income.   The
increase in the number of demand deposit customers over the past year
contributed to the improvement in deposit fee income. Mortgage banking fees were
higher primarily due to increased refinancing activity in the local housing
market as a result of lower long-term mortgage rates.  Other fee
income increased primarily due to an increase in the fair value adjustment on
deferred compensation assets, which is directly offset by a corresponding
decrease in noninterest expense, resulting in no net impact on
earnings.





These
increases in noninterest income were partly offset by a $40,000 decrease in
dividends on FHLB stock and a $48,000 decrease in other loan fees. The FHLB
suspended its dividend in 2008, resulting in no dividend payments during the
first half of 2009.  In the third quarter of 2009 the FHLB reinstated
the dividend at a rate of 0.4%, which was a much lower rate than the 5.0%
dividend rate paid in 2008.  The reduction in other loan fee income
was largely due to reduced construction loan activity resulting from the
economic slowdown that is expected to last through 2009 and into
2010.





Noninterest
expense.Noninterest expense
increased by $84,000, or 1.6%, to $5.2 million for the quarter ended September
30, 2009.  The primary reasons for this increase were a $207,000
increase in FDIC deposit insurance premiums, a $33,000 increase in professional
fees, and a $37,000 increase in other noninterest expenses.  The
increase in FDIC insurance premiums was due to the fact that the FDIC revised
the formula for calculating deposit insurance premiums in an effort to replenish
the deposit insurance fund, resulting in higher deposit insurance premiums for
the Bank.  These deposit premium increases are expected to continue
throughout the foreseeable future.  The FDIC may charge special
assessments or make further adjustments in the formula used to calculate future
deposit insurance premiums if needed. Professional fees primarily increased due
to higher legal fees resulting in part from changes in various rules and
regulations impacting the operation of the Company.  Other noninterest
expenses increased primarily due to higher collection expenses resulting from an
increased number of past due loans.


23


These
increases in noninterest expense were partly offset by a $30,000 decrease in
occupancy and equipment expense, a $45,000 decrease in the amortization of
intangible assets and a $135,000 decrease in the impairment of
securities.  The decrease in occupancy and equipment expense was
largely due to the expiration of depreciation expense related to the Company’s
core processing system. The amortization of intangible assets is expected to
continue to decrease as the amount of the core deposit intangible
decreases.  The impairment of securities during both periods was
attributable to the same $1.0 million pooled trust preferred
security.





Income
taxes.Income taxes amounted
to a benefit of $672,000 for the quarter ended September 30,
2009.  This benefit was largely due to the fact that nontaxable income
generated from interest earned on bank-qualified municipal securities and loans
exceeded the Company’s provision for taxable income.  This nontaxable
income was primarily generated from interest earned on bank-qualified municipal
securities and increases in cash value on bank-owned life insurance
policies.  The Company invests in tax-advantaged sources of income to
reduce its overall tax burden.  However, as the Company continues to
increase the amount of income derived from interest income on loans and fee
income on loans and deposits, the effective tax rate is expected to
increase.  During the third quarter of 2008 the Company’s income tax
expense totaled $187,000, or 18.5% of taxable income.





Comparison
of Results of Operations for the Nine Months Ended September 30, 2009 and
2008





General.  Net loss
available to common stockholders for the nine months ended September 30, 2009,
amounted to $501,000, or $0.07 per diluted share, as compared to net income of
$2.7 million, or $0.36 per diluted share, for the nine months ended September
30, 2008.  This decrease was largely due to increased credit losses
arising as a result of a slowing economy and a special assessment by the FDIC
that was charged to all FDIC-insured financial institutions. Also, during the
nine months ended September 30, 2009, the Company paid $774,000 in dividends on
$20.5 million of preferred stock issued by the U.S. Treasury, as compared to no
preferred dividend payments during the nine months ended September 30,
2008.





Net interest
income.
Interest income decreased by $3.4 million, or 10.6%, to $28.8 million for the
nine months ending September 30, 2009, primarily as a result of a 400 basis
point decrease in short-term market interest rates during 2008.  With
approximately 46% of the Company’s loan portfolio scheduled to reprice on a
monthly basis, the Company’s average yield on earning assets decreased by 97
basis points for the comparable periods to 5.25% for the nine months ended
September 30, 2009. The Company was able to offset some of the negative effects
of this decrease in yield through asset growth. Average interest-earning assets
increased by $44.4 million, or 6.3%, to $744.6 million for the nine months ended
September 30, 2009. The increase in average interest-earning assets was
primarily the result of a $38.2 million, or 6.5%, increase in average
outstanding loans to $628.8 million for the nine-month period ended September
30, 2009.





Interest
expense decreased by $4.2 million, or 24.4%, for the comparable periods to $13.0
million for the nine months ended September 30, 2009.  This decrease
in interest expense was largely due to lower market interest rates, which
resulted in a 90 basis points decrease in the average cost of funds to 2.58% for
the nine months ended September 30, 2009. This benefit of lower costing
liabilities was partly offset by a $19.0 million, or 2.9%, increase in the
average balance of interest-bearing liabilities to $678.4 million for the nine
months ended September 30, 2009. Average interest-bearing liabilities increased
primarily as a result of a $25.0 million, or 4.7%, increase in average
interest-bearing deposits which was partly offset by a $6.1 million, or 5.0%,
decrease in average borrowed money.





As a
result of the decrease in short-term interest rates during the periods, the
Company’s net interest margin decreased by four basis points to 2.92% for the
nine months ended September 30, 2009, compared to 2.96% for the nine months
ended September 30, 2008. This decrease in the net interest margin was primarily
the result of yields on earning assets falling at a faster rate than the cost of
funds. However, on a linked-quarter basis, the Company’s net interest margin
increased by 11 basis points from 2.92% for the second quarter of 2009 to 3.03%
for the third quarter of 2009.  While the Company maintains a
relatively neutral interest rate risk position on a cumulative one-year basis,
the Federal Reserve Board’s action to lower short-term interest rates by 200
basis points in the fourth quarter of 2008 had a more pronounced negative impact
during the first three months following the decrease.  The short-term
negative effects of the decrease in interest rates have been mostly offset by
time deposits that matured   and repriced at a lower cost to the
Company.


24





Provision for
loan losses.Due to the general weakness in the local economy and an
increase in nonperforming assets, the Company increased its provision for loan
losses to $6.8 million for the first nine months of 2009, compared to $1.8
million for the first nine months of 2008.  As a result, the allowance
for loan losses was $9.5 million, or 1.54% of total loans, as of September 30,
2009, compared to $7.0 million, or 1.12% of total loans, as of September 30,
2008. While the Company’s credit quality continues to compare favorably with
industry peers, the continued decline in local economic conditions has resulted
in an upward trend in the Company’s loan delinquency
ratios.   The Company’s ratio of non-performing assets to total
assets increased from 0.53% at September 30, 2008, to 1.73% at September 30,
2009. A substantial portion of the Company’s nonperforming loans at September
30, 2009, was secured by real estate located in the Company’s normal lending
market.  Net charge offs totaled $5.4 million, or 1.13% (annualized)
of average loans, during the nine months ended September 30, 2009 compared to
$932,000, or 0.20% (annualized) of average loans, for the nine months ended
September 30, 2008.  Based on a recent review of the Company’s loan
portfolio by the Bank’s federal regulator and minor improvements in the local
economy, management believes that problem loans are
manageable.  However, management expects that the Company will
continue to experience larger than normal loan loss provisions over the
foreseeable future.




Noninterest
income.Noninterest
income increased by $1.0 million, or 21.0%, to $5.7 million for the nine months
ended September 30, 2009. This increase was largely attributable to a $742,000
increase in the net gain on sale of assets for the comparable
periods.  During the first nine months of 2009, the Company sold ten
residential properties and one commercial property totaling $2.2 million that
were acquired through foreclosure at a net loss of $263,000. The Company also
sold $48.0 million in investment securities at a net gain of $1.3 million and
$815,000 of land and other miscellaneous assets at a loss of
$1,000.  During the first nine months of 2008 the Company recognized a
$284,000 net gain from the sale of $31.8 million in investment securities and
$16,000 in net losses from the sale of $295,000 in foreclosed properties and a
$7,000 gain from the sale of $15,000 in miscellaneous fixed assets.





The
remainder of this increase in noninterest income was partly due to a $172,000
increase in fees on deposits, a $325,000 increase in mortgage banking fee income
and a $54,000 increase in other noninterest income.   The
increase in the number of demand deposit customers over the past year
contributed to the improvement in deposit fee income.  Mortgage
banking fee income was higher primarily due to increased refinancing activity in
the housing market as a result of lower long-term mortgage
rates.  Other noninterest income increased due to mark-to-market
adjustments made to the Company’s deferred compensation assets.  This
mark-to-market entry was directly offset by a corresponding adjustment to
compensation, resulting in no impact on the Company’s net income.





These
increases were partly offset by a $168,000 decrease in dividends on FHLB stock
and a $122,000 decrease in other loan fees.  The FHLB suspended its
dividend in 2008, resulting in no dividend payments during the first half of
2009.  The FHLB reinstated the dividend during the third quarter of
2009 at a rate of 0.4% which was substantially lower than the 5.0% dividend rate
paid in 2008.  The reduction in fee income from lending activities was
largely due to reduced construction loan activity resulting from the economic
slowdown that is expected to last through 2009.





Noninterest
expense.Noninterest expense
increased by $675,000, or 4.6%, to $15.4 million for the nine months ended
September 30, 2009.  The primary reasons for this increase were a
$175,000 writedown on a foreclosed residential property, a $79,000 increase in
the impairment on securities, a $767,000 increase in FDIC deposit insurance
premiums, a $68,000 increase in professional fees and a $32,000 increase in
other noninterest expense.  The writedown on the foreclosed property
was the result of a softening in residential sales prices for similarly priced
properties located near the Company’s foreclosed property.  Additional
valuation adjustments on foreclosed properties may be recognized if sales prices
for local properties continue to soften. The other-than-temporary impairment was
on two equity investments and a pooled trust preferred security.  The
first equity investment was common stock in the Company’s correspondent bank,
which was taken into receivership by the FDIC during the second quarter of 2009.
The other equity investment was common stock in a closely held trust company
that was determined to be other-than-temporarily impaired due to declining
balances of assets under management and a declining customer
base.  The Bank took a $333,000 and a $468,000 impairment on the same
$1.0 million pooled trust preferred security for the nine-month periods ended
September 30, 2009, and September 30, 2008, respectively. The FDIC insurance
premiums increased due to the fact that the FDIC revised the formula for
calculating deposit insurance premiums in an effort to replenish the deposit
insurance fund, resulting in higher deposit insurance premiums for the
Bank.  These deposit premium increases are expected to continue for
the foreseeable future.  In addition, the FDIC charged all
FDIC-insured financial institutions a special assessment of five basis points on
total assets at September 30, 2009, which resulted in an additional premium
expense of $380,000 for the second quarter of 2009.  The FDIC may
charge one or more additional special assessments in the future if needed. The
increase in professional fees was partly due to increased legal fees paid for
services related to ensuring compliance with TARP restrictions.  The
increase in noninterest expenses was primarily related to increase collection
expenses resulting from an elevated level of past due loans over the comparable
periods.


25


These
increases in noninterest expense were partly offset by a $220,000 reduction in
restructuring expenses, a $12,000 reduction in compensation and benefits, a
$159,000 decrease in the amortization of intangible assets, and a $55,000
reduction in occupancy and equipment expense.  The restructuring
expense was attributable to severance payments made to various employees whose
positions were eliminated during the first quarter of 2008.  As a part
of the restructuring, four positions were eliminated and three leased loan
production offices were consolidated into existing facilities.  No
additional expenses are expected in conjunction with the reorganization. As a
result of this reorganization in 2008, the Company’s compensation and benefits
decreased during the nine months ended September 30, 2009, as compared to the
nine months ended September 30, 2008.  The amortization of intangible
assets is expected to continue to decrease as the amount of the core deposit
intangible decreases.  The decrease in occupancy and equipment expense
was largely due to the expiration of depreciation expense related to the
Company’s core processing system.





Income
taxes.Income taxes amounted
to a benefit of $887,000 for the nine months ended September 30,
2009.  This benefit was largely due to the fact that nontaxable income
generated from interest earned on bank-qualified municipal securities and loans
exceeded the Company’s provision for taxable income.  This nontaxable
income was primarily generated from interest earned on bank-qualified municipal
securities and increases in cash value on bank-owned life insurance
policies.  The Company invests in tax-advantaged sources of income to
reduce its overall tax burden.  However, as the Company continues to
increase the amount of income derived from interest income on loans and fee
income on loans and deposits, the effective tax rate is expected to increase.
During the nine months ending September 30, 2008 the Company’s income tax
expense totaled $647,000, or 19.6% of taxable income.





Liquidity





The
objectives of the Company’s liquidity management policy include providing
adequate funds to meet the cash needs of both borrowers and depositors, to
provide for the on-going operations of the Company, and to capitalize on
opportunities for expansion.  Liquidity management addresses the
Company’s ability to meet deposit withdrawals on demand or at contractual
maturity, to repay borrowings as they mature, and to fund new loans and
investments as opportunities arise.  The primary sources of internally
generated funds are principal and interest payments on loans receivable,
increases in local deposits, cash flows generated from operations, and cash
flows generated by investments.  If the Company requires funds beyond
its internal funding capabilities, it may rely upon external sources of funds
such as brokered deposits, repurchase agreements, and advances.  The
Company has $91.6 million available to draw from its line of credit with the
FHLB.  The FHLB functions as a central reserve bank providing credit
for member financial institutions. As a member of the FHLB, we are required to
own capital stock in the FHLB and we are authorized to apply for advances on the
security of such stock and certain of our mortgage loans and other assets
(principally securities that are obligations of, or guaranteed by, U.S.
Government Agencies, or Government Sponsored Enterprises) provided certain
creditworthiness standards have been met. Advances are made pursuant to several
different credit programs. Each credit program has its own interest rate and
range of maturities. Depending on the program, limitations on the amount of
advances are based on the financial condition of the member institution and the
adequacy of collateral pledged to secure the credit.  The Company also
has $16.0 million available from an unsecured federal funds accommodation with
Pacific Coast Bankers Bank (“PCBB”).  PCBB is the Company’s primary
correspondent bank. The federal funds facility is for a term of 12 months and is
used for the purpose of providing daily liquidity as needed by the
Company.  Outstanding advances made under this facility are generally
repaid on a daily basis at a rate determined by PCBB based on their marginal
cost of funds.  Advances are limited to not more than 10 consecutive
days at a time.  The Company may also solicit brokered deposits for
providing funds for asset growth.  As of September 30, 2009, the
Company had outstanding brokered deposits of $99,000. The Company believes that
it has sufficient sources of liquidity to fund the cash needs of both borrowers
and depositors, to provide for the ongoing operations of the Company, and to
capitalize on opportunities for expansion.


26





In the
normal course of business, various commitments are outstanding that are not
reflected in the consolidated financial statements.  Commitments to
extend credit and undisbursed advances on customer lines of credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract.  The funding of these
commitments and previously approved undisbursed lines of credit could affect the
Company's liquidity position.  At September 30, 2009, the Company had
loan commitments of $19.3 million, unused lines of credit of $96.4 million, and
undisbursed construction loan proceeds of $753,000.  The Company
believes that it has adequate resources to fund loan commitments and lines of
credit as they arise.  The Company does not have any special purpose
entities or other similar forms of off-balance-sheet financing.





Capital
Resources





On
December 12, 2008, the Company entered into a Letter Agreement (the "Purchase
Agreement") with the U.S. Treasury pursuant to which the Company has issued and
sold to the U.S. Treasury: (i) 20,500 shares of the Company's Fixed Rate
Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share,
having a liquidation amount per share equal to $1,000, for a total price of
$20,500,000 and (ii) a warrant to purchase 428,870 shares of the Company's
common stock, par value $0.01 per share, at an exercise price per share of
$7.17. The warrant has a ten-year term and is immediately exercisable. The
warrant provides for the adjustment of the exercise price and the number of
shares of the Company's common stock issuable upon exercise pursuant to
customary anti-dilution provisions, such as upon stock splits or distributions
of securities or other assets to holders of the Company's common stock, and upon
certain issuances of the Company's common stock at or below a specified price
relative to the then current market price of the Company's common stock. If, on
or prior to December 31, 2009, the Company receives aggregate gross cash
proceeds of not less than the purchase price of the Series A Preferred Stock
from one or more "qualified equity offerings," the number of shares of common
stock issuable pursuant to the warrant will be reduced by one-half of the
original number of shares, taking into account all adjustments. Management does
not expect to such proceeds from a “qualified equity offering” prior to December
31, 2009.   Pursuant to the Purchase Agreement, the U.S. Treasury
has agreed not to exercise voting power with respect to any shares of common
stock issued upon exercise of the warrant.  Both the Series A
Preferred Stock and warrant are accounted for as components of Tier 1
capital.





The
Series A Preferred Stock pays cumulative dividends at a rate of 5% per annum for
the first five years and thereafter at a rate of 9% per annum.  The
Series A Preferred Stock can be repaid at any time with the approval of the
OTS.  The Series A Preferred Stock is generally non-voting. Prior to
December 12, 2011, and unless the Company has redeemed all of the Series A
Preferred Stock or the U.S. Treasury has transferred all of the Series A
Preferred Stock to a third party, the approval of the U.S. Treasury will be
required for the Company to increase its common stock dividend or repurchase its
common stock or other equity or capital securities, other than in certain
circumstances specified in the Purchase Agreement.   In addition,
the U.S. Treasury placed certain restrictions on the amount and type of
compensation that can be paid to certain senior level executives of the
Company.





The Bank
is subject to various regulatory capital requirements administered by the
banking regulatory agencies. Failure to meet minimum capital requirements can
result in certain mandatory and possibly discretionary actions by the regulators
that, if undertaken, could have a direct material effect on the Bank’s financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank’s assets, liabilities,
and certain off-balance-sheet items as calculated under regulatory accounting
practices.  The Bank’s capital amounts and classifications are subject
to qualitative judgments by the regulators about components, risk-weightings,
and other factors.





The
Bank’s actual capital levels and regulatory capital ratios as of September 30,
2009, are presented in the following table.


27





Regulatory Capital Ratios:
                  
                  Actual
                  
                  
                  Minimum
                    Requirements to be
                    Well Capitalized(Dollars
      in Thousands)
                  
                  Amount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  RatioCitizens
      South Bank:Total
      Risk-Based Capital (to risk-weighted assets)
                  
                  $
                  90,297
                  
                  
                  
                  14.41
                  %
                  
                  $
                  62,671
                  
                  
                  
                  10.00
                  %Tier
      1 Capital (to risk-weighted assets)
                  
                  
                  83,123
                  
                  
                  
                  13.26
                  %
                  
                  
                  37,603
                  
                  
                  
                  6.00
                  %Tier
      1 Capital (to adjusted total assets)
                  
                  
                  83,123
                  
                  
                  
                  10.53
                  %
                  
                  
                  39,486
                  
                  
                  
                  5.00
                  %Tangible
      Capital (to adjusted total assets)
                  
                  
                  83,123
                  
                  
                  
                  10.53
                  %
                  
                  
                  23,691
                  
                  
                  
                  3.00
                  %





ITEM
3.  Quantitative and Qualitative Disclosures About Market
Risk





As
described in more detail in our Annual Report on Form 10-K for the year ended
December 31, 2008, asset/liability management involves the evaluation,
monitoring and management of interest rate risk, liquidity and funding. While
the Board of Directors has overall responsibility for the Company’s
asset/liability management policies, the Bank’s Asset and Liability Committee
monitors loan, investment, and liability portfolios to ensure comprehensive
management of interest rate risk and adherence to the Bank’s policies.
Management does not believe there has been any significant change in the overall
sensitivity of its interest-earning assets and interest-bearing liabilities from
the results presented in the Annual Report on Form 10-K for the year ended
December 31, 2008.





ITEM
4.  Controls and Procedures





Our
management, with the participation of our Principal Executive Officer and our
Principal Financial Officer, has evaluated the effectiveness of the design and
operation of our disclosure controls and procedures in accordance with Rule
13a-15 of the Securities Exchange Act of 1934 (the “Exchange
Act”).  Based upon their evaluation, our Principal Executive Officer
and our Principal Financial Officer concluded that, as of the end of the period
covered by this report, the Company’s disclosure controls and procedures were
effective.





There has
been no change in the Company’s internal control over financial reporting
identified in connection with the quarterly evaluation that occurred during the
Company’s last fiscal quarter that has materially affected, or is reasonably
likely to materially affect, the Company’s internal control over financial
reporting.


28


PART
II.  OTHER INFORMATION





Item
1.   Legal Proceedings





There are
various claims and lawsuits in which the Bank is periodically involved
incidental to the Company's business.  In the opinion of management,
no material loss is expected from any of such pending claims or
lawsuits.





Item
1A.  Risk Factors





In
addition to the other information contained this Quarterly Report on Form 10-Q,
the following risk factors represent material updates and additions to the risk
factors previously disclosed in the Company’s Annual Report on Form 10-K for the
Fiscal Year Ended December 31, 2008, as filed with the Securities and Exchange
Commission (“SEC”) as well other filings with the SEC.  Additional
risks not presently known to us, or that we currently deem immaterial, may also
adversely affect our business, financial condition or results of operations.
Further, to the extent that any of the information contained in this Quarterly
Report on Form 10-Q constitutes forward-looking statements, the risk factor set
forth below also is a cautionary statement identifying important
factors that could cause our actual results to differ materially from those
expressed in any forward-looking statements made by or on behalf of
us.




We
hold certain intangible assets that could be classified as impaired in the
future.  If these assets are considered to be either partially or
fully impaired in the future, our earnings and the book values of these assets
would decrease.




We are
required to test our goodwill and core deposit intangible assets for impairment
on a periodic basis.  The impairment testing process considers a
variety of factors, including the current market price of our common shares, the
estimated net present value of our assets and liabilities and information
concerning the terminal valuation of similarly situated insured depository
institutions.  It is possible that future impairment testing could
result in a partial or full impairment of the value of our goodwill or core
deposit intangible assets, or both.  If an impairment determination is
made in a future reporting period, our earnings and the book value of these
intangible assets will be reduced by the amount of the
impairment.




Any
future increases in Federal Deposit Insurance Corporation insurance premiums
will adversely impact our earnings.  In addition, the Federal Deposit
Insurance Corporation has proposed to require the prepayment of three years of
federal deposit insurance premiums.




On May
22, 2009, the Federal Deposit Insurance Corporation adopted a final rule levying
a five basis point special assessment on each insured depository institution’s
assets minus Tier 1 capital as of June 30, 2009.  The special
assessment was payable on September 30, 2009.  We recorded an expense
of $380,000 during the quarter ended June 30, 2009, to reflect the special
assessment.  The final rule permits the Federal Deposit Insurance
Corporation’s Board of Directors to levy up to two additional special
assessments of up to five basis points each during 2009 if the Federal Deposit
Insurance Corporation estimates that the Deposit Insurance Fund reserve ratio
will fall to a level that the Federal Deposit Insurance Corporation’s Board of
Directors believes would adversely affect public confidence or to a level that
will be close to or below zero.   Any further special assessments that
the Federal Deposit Insurance Corporation levies will be recorded as an expense
during the appropriate period.  In addition, the Federal Deposit
Insurance Corporation materially increased the general assessment rate and,
therefore, our Federal Deposit Insurance Corporation general insurance premium
expense will increase substantially compared to prior periods.





On
September 28, 2009, the Federal Deposit Insurance Corporation proposed to
recapitalize the Deposit Insurance Fund by requiring insured institutions to
prepay their insurance premiums for the quarter ending December 31, 2009 and for
the years ending December 31, 2010, 2011 and 2012.  The prepayment
would be due December 30, 2009.  The Federal Deposit Insurance
Corporation further proposed that assessments for the years ending December 31,
2011 and 2012 would increase by three basis points, and would be based upon
assumed increases in insured deposits of 5% annually through
2012.  The increase in assessment rates will result in a further
increase in our Federal Deposit Insurance Corporation general insurance premium
expense, and the prepayment of insurance premiums will increase our non-earning
assets.


29





If
our non-performing assets increase, our earnings will suffer.





At
September 30, 2009, our non-performing assets (which consist of non-accruing
loans, loans 90 or more days delinquent, and foreclosed real estate assets)
totaled $14.1 million, or 1.72% of total assets, which is an increase of $8.5
million or 151.1% over non-performing assets at December 31, 2008.  At
December 31, 2008, our non-performing assets were $5.6 million, or 0.69% of
total assets. Our non-performing assets adversely affect our net income in
various ways.  We do not record interest income on non-accrual loans
or real estate owned.  Additionally, there are legal fees associated
with the resolution of problem assets as well as carrying costs such as taxes,
insurance and maintenance related to our other real estate
owned.  Further, the resolution of non-performing assets requires the
active involvement of management, which can distract them from more profitable
activity.





Changes
in local economic conditions could lead to higher loan charge-offs and reduce
our net income and growth.





Our
business is subject to periodic fluctuations based on local economic conditions
in the Charlotte MSA. These fluctuations are not predictable, cannot be
controlled and may have a material adverse impact on our operations and
financial condition even if other favorable events occur. Our operations are
locally oriented and community-based. Accordingly, we expect to continue to be
dependent upon local business conditions as well as conditions in the local
residential and commercial real estate markets we serve. For example, an
increase in unemployment, a decrease in real estate values or increases in
interest rates, as well as other factors, could weaken the economies of the
communities we serve.





Weakness
in our market areas could depress our earnings and consequently our financial
condition because:





·
            customers
      may not want or need our products or
services;





·
            borrowers
      may not be able to repay their
loans;





·
            the
      value of the collateral securing loans to borrowers may decline;
      and





·
            the
      quality of our loan portfolio may
decline.





Any of
the latter three scenarios could require us to charge off a higher percentage of
loans and/or increase provisions for credit losses, which would reduce our net
income.





Because
the majority of our borrowers are individuals and businesses located and doing
business in the Charlotte MSA, our success will depend significantly upon the
economic conditions in those and the surrounding counties. Unfavorable economic
conditions in those and the surrounding counties may result in, among other
things, a deterioration in credit quality or a reduced demand for credit and may
harm the financial stability of our customers. Due to our limited market areas,
these negative conditions may have a more noticeable effect on us than would be
experienced by a larger institution that is able to spread these risks of
unfavorable local economic conditions across a large number of diversified
economies.





In
addition, we have added a significant number of loans over the past five years
from new relationships as we have entered new markets through acquisitions and
de novo
offices.  As a result, our loan portfolio may not be as seasoned as
the loan portfolios of our competitors in some of these new markets, and
weaknesses in these market areas could have a more negative effect on our loans
compared to loans originated by our competitors in the same market
areas.


30




A
significant portion of our loan portfolio is secured by real estate, and events
that negatively impact the real estate market could hurt our
business.




A
significant portion of our loan portfolio is secured by real estate. As of
September 30, 2009, approximately 92.9% of our loans had real estate as a
primary or secondary component of collateral. The real estate collateral in each
case provides an alternate source of repayment in the event of default by the
borrower and may deteriorate in value during the time the credit is extended. A
weakening of the real estate market in our primary market areas could result in
an increase in the number of borrowers who default on their loans and a
reduction in the value of the collateral securing their loans, which in turn
could have an adverse effect on our profitability and asset quality. If we are
required to liquidate the collateral securing a loan to satisfy the debt during
a period of reduced real estate values, our earnings and shareholders’ equity
could be adversely affected. The declines in home prices in the markets we
serve, along with the reduced availability of mortgage credit, also may result
in increases in delinquencies and losses in our portfolio of loans related to
residential real estate construction and development. Further declines in home
prices coupled with a deepened economic recession and continued rises in
unemployment levels could drive losses beyond that which is provided for in our
allowance for loan losses. In that event, our earnings could be adversely
affected.





A
substantial decline in the value of our Federal Home Loan Bank of Atlanta common
stock may adversely affect our financial condition.





We own
common stock of the Federal Home Loan Bank of Atlanta in order to qualify for
membership in the Federal Home Loan Bank system, which enables us to borrow
funds under the Federal Home Loan Bank advance program.  The carrying
value and fair market value of our Federal Home Loan Bank of Atlanta common
stock was $4.1 million as of September 30, 2009.





Recent
published reports indicate that certain member banks of the Federal Home Loan
Bank system may be subject to asset quality risks that could result in
materially lower regulatory capital levels.  In an extreme situation,
it is possible that the capitalization of a Federal Home Loan Bank, including
the Federal Home Loan Bank of Atlanta, could be substantially diminished or
reduced to zero.  Consequently, given that there is no market for our
Federal Home Loan Bank of Atlanta common stock, we believe that there is a risk
that our investment could be deemed other than temporarily impaired at some time
in the future.  If this occurs, it may adversely affect our results of
operations and financial condition.





If the
capitalization of the Federal Home Loan Bank of Atlanta is substantially
diminished and if it reduces or suspends its dividend, our liquidity may be
adversely impaired if we are not able to obtain an alternative source of
funding.





We
may face risks with respect to future expansion.





As a
strategy, we have sought to increase the size of our operations by aggressively
pursuing business development opportunities. We may seek whole bank or branch
acquisitions in the future. Acquisitions and mergers involve a number of risks,
including:





· the
time and costs associated with identifying and evaluating potential acquisitions
and merger partners;





· the
ability to finance an acquisition and possible ownership and economic dilution
to existing stockholders;





· diversion
of management’s attention to the negotiation of a transaction, and the
integration of the operations and personnel of the acquired
institution;





31


· the
incurrence and possible impairment of goodwill associated with an acquisition
and possible adverse short-term effects on results of operations;
and





· the
risk of loss of key employees and customers.





We may
incur substantial costs to expand, and such expansion may not result in the
levels of profits we seek.  Integration efforts for any future mergers
and acquisitions may not be successful and following any future merger or
acquisition, after giving it effect, we may not achieve financial results
comparable to or better than our historical experience.





The
loss of key personnel may adversely affect us.





Our
success is, and expected to remain, highly dependent on our senior management
team and key loan officers. As a community bank, our management’s extensive
knowledge of and relationships in the community generate a significant portion
of our business.  Successful execution of our growth strategy will
continue to place significant demands on our management and the loss of any such
person’s services may adversely affect our growth and
profitability.





Confidential
customer information transmitted through our online banking service is
vulnerable to security breaches and computer viruses, which could expose us to
litigation and adversely affect our reputation and ability to generate
deposits.





Citizens
South Bank provides its customers the ability to bank online. The secure
transmission of confidential information over the Internet is a critical element
of online banking. While we use third party vendors to test and audit our
network, our network could become vulnerable to unauthorized access, computer
viruses, phishing schemes and other security problems. Citizens South Bank may
be required to spend significant capital and other resources to protect against
the threat of security breaches and computer viruses, or to alleviate problems
caused by security breaches or viruses. To the extent that Citizens South Bank’s
activities or the activities of its customers involve the storage and
transmission of confidential information, security breaches and viruses could
expose Citizens South Bank to claims, litigation and other possible liabilities.
Any inability to prevent security breaches or computer viruses could also cause
existing customers to lose confidence in Citizens South Bank’s systems and could
adversely affect its reputation and its ability to generate
deposits.





Item
      2.
            Unregistered
      Sales of Equity Securities and Use of
Proceeds





During
the three-month period ended September 30, 2009, the Company did not repurchase
any shares of common stock.





As of
September 30, 2009, the Company had repurchased a total of 3,213,911 shares, or
35.5% of the outstanding shares of common stock, at an average price of
$13.06.  This stock was repurchased under a series of repurchase
programs that have been authorized by the Board of Directors over the past
several years.  The most recent repurchase authorization was granted
by the Board of Directors in September 2008, for the repurchase of up to 200,000
shares, or approximately 2.7% of the Company’s then outstanding shares of common
stock.  As of September 30, 2009, the Company had repurchased a total
of 9,476 shares at an average price of $7.91 per share and had 190,524 shares
remaining to be repurchased under this plan.  On December 12, 2008,
the Company entered into a Letter Agreement with the U.S. Treasury pursuant to
which the Company has issued and sold to the U.S. Treasury: (i) 20,500 shares of
the Company's Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par
value $0.01 per share, having a liquidation amount per share equal to $1,000,
for a total price of $20,500,000 and (ii) a warrant to purchase 428,870 shares
of the Company's common stock, par value $0.01 per share, at an exercise price
per share of $7.17.  As a condition for issuing the preferred stock,
the U.S. Treasury limited the Company’s ability to repurchase common stock of
the Company and increase its dividend payments to stockholders without receiving
prior approval from the U.S. Treasury.   As a result, future
repurchases of Company common stock are not anticipated for
2009.


32


Item
      3.
            Defaults
      Upon Senior Securities





None.





Item
      4.
            Submission
      of Matters to a Vote of Security
Holders





None.





Item
      5.
            Other
      Information





None.





Item
      6.
            Exhibits





31.1
              Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
              Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1
              Written
      statement of Chief Executive Officer furnished pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002.32.2
              Written
      statement of Chief Financial Officer furnished pursuant to Section 906 of
      the Sarbanes-Oxley Act of
2002.




33


SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





Citizens
      South Banking CorporationDate:
      November 12, 2009
                  By:
                  /s/ Kim S. PriceKim
      S. PricePresident
      and Chief Executive OfficerDate:
      November 12, 2009
                  By:
                  /s/ Gary F. HoskinsGary
      F. HoskinsExecutive
      Vice President, Chief Financial Officer
                    and
      Treasurer


34